Diversification Intensive of Risk Premia

A long criticism on the usefulness of the traditional CAPM model has been raised in the vast literature of arbitrage pricing models that propose several risk factors on firm fundamentals or investigate the stochastic properties of stock returns' distributions, (Fama and French (2004)). However, our paper provides evidence of misspecification issues in the empirical formulations of most of these multifactor models. We reveal that existing self-financing strategies on size, value, momentum, liquidity and financial distress may contain residual idiosyncratic risk because of the existence of asymmetric diversification effects. Using data from the main US exchanges, there is strong evidence of over- and under-estimation of factor risk premia relevant to their intrinsic values. We propose an amended multifactor asset pricing model, the diversification risk premium model, to control for the intertemporal asymmetric idiosyncratic risk. Overall, our results suggest that portfolios formed on size and liquidity suffer from diversification asymmetries. Specifically, the size effect dies out when the asymmetric effect on idiosyncratic risk is accounted for. Moreover, investing on valued and financially distressed firms yields consistently positive returns associated with the systematic component of risk of the corresponding risk factors. Finally, there is evidence that the presence of risk factors is enhanced during periods of low inter-dependencies between securities' returns