The objective of this research is to re-examine the relationship between idiosyncratic risk and expected stock returns using panel threshold regression method in Taiwan stock market. According to CAPM, idiosyncratic risk should not bear a relationship with expected stock returns because it can be diversified away. This paper employs threshold regression model to uncover the underlying relationship between idiosyncratic risk and expected stock returns in Taiwan stock market from 1994/1 to 2013/12. Grounded on Merton (1987) that a positive relation exists between idiosyncratic risk and stock returns because investors are not well-diversified, we hypothesize that investors’ incentive to diversify varies over time. Our results support Merton (1987) argument, the relationship between idiosyncratic risk and expected stock returns are often positive. However, when investors have strong incentive to well-diversify the idiosyncratic risk in their investments during a bear market, a weaker or no relation exists. In other words, investors’ diversified degree of the idiosyncratic risk in their investmentsvaries with economic cycle and time and the positive relationship between idiosyncratic risk and expected stock returns doesn't always hold. The results will help reconcile the conflicting results found in the literatures.
Expected stock returns; CAPM; Idiosyncratic risk; Panel threshold regression
