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Authors:

• Xuying CAO
  University of Texas at Dallas

• Yexiao XU
  University of Texas at Dallas

This paper reconciles the conflicting evidence on the cross-sectional pricing of idiosyncratic risk. Some studies find a negative relation, while others document a positive relation between idiosyncratic volatiilities and future returns on individual stocks. In contrast to the common practice of applying total idiosyncratic volatilities, we decompose the volatility into long- and short-run components. As a result, we find that stocks with high long-run idiosyncratic risks have large future returns. On the contrary, the short-run idiosyncratic risk component is negatively related to stock returns. This finding suggests that different relations documented in the current literature depend on the dominance of the long- versus the short-run components of the idiosyncratic risk reflected in the particular measure used by a study. Our results are robust to model specifications, sample periods, different samples of stocks, and the possible January effect.