Idiosyncratic risk matters! A regime switching approach

The evidence on the inter-temporal relation between idiosyncratic risk and future stock returns is conflicting and confusing. We shed new light on the issue using a more flexible econometric approach based on [Hamilton, J.D. 1989. A new approach to the economic analysis of nonstationary time series and the business cycle. Econometrica, 57, 357-384.] regime switching model that accommodates the parameter instability of the forecasting relation between returns and financial variables. We find strong evidence suggesting that idiosyncratic risk is related to future stock market returns only in the low variance regime.