Study On The Relationship Between Idiosyncratic Risk And Stock Returns

The relationship between stock returns and risk of investment is always at the core of financial theory research. In recent years, research on idiosyncratic risk and stock returns has been gaining more and more scholarly attention, the empirical evidence, however, is mixed. Domestic research largely relies on portfolio analysis to examine this relationship, yet this qualitative analys is is rather preliminary. In this study, I first adopt Quantile Regression to provide a more accurate test of the relationship between idiosyncratic risk and stock returns. I then draw on asset pricing model and behavioral finance theory to introduce heter ogeneous beliefs to the study of the relationship. Hierarchical analysis is used to further explore the relationship between heterogeneous beliefs, stock returns and idiosyncratic risk.This study uses companies listed on the main board market of Shanghai Stock Exchange from January 2006 to June 2014 as the sample. Firstly, I use the Fama-French three-factor model to estimate the monthly value of idiosyncratic risk of sample stocks based on daily stock data. Secondly, the relationship between idiosyncratic risk and stock returns is tested by Portfolio Analysis roughly and then by Quantile Regression Analysis subtly. Negative correlation between idiosyncratic risk and stock returns was only found in low-return sample stocks. In contrast, positive correlation was found in high-return stocks and the positive correlation becomes stronger as the stock return goes higher. Thirdly, the positive effect of heterogeneous beliefs on stock returns is examined using two-step Fama-Macbeth regression analysis. Lastly, heterogeneous beliefs was found to moderate the relationship between idiosyncratic risk and stock returns, such that positive relationship between idiosyncratic risk and stock returns was found when heterogeneous beliefs is high rather than low.In this study, the relationship between idiosyncratic risk and stock returns was tested using various methods, which makes a methodological contribution to the idiosyncratic risk research. This study also makes theoretical contributions to the literature by integrating the behavioral finance theory and asset pricing model to examine the relationship between idiosyncratic risk and stock returns.