An examination of idiosyncratic volatility in Australia.

In finance, the pricing of assets is an area of fundamental importance. Many theories and their associated models have been proposed. The Capital Asset Pricing Model is arguably the most important of these as it provides the basis for many other asset pricing models. The theory of the Capital Asset Pricing Model states that investors should be compensated for higher systematic risk taken but should not be compensated for higher unsystematic risk or idiosyncratic volatility taken. The reason for this is that the Capital Asset Pricing Model suggests that idiosyncratic volatility should be ignored since investors are assumed to hold proportions of the well diversified market portfolio. Therefore, idiosyncratic volatility is fully diversified away in their portfolios and only systematic risk should be priced. However, it is not realistic to assume that every investor holds a proportion of the well diversified market portfolio in the real world because of market imperfections such as transaction costs and/or limited knowledge in all securities. Hence, idiosyncratic volatility should not be ignored in the area of asset pricing