Idiosyncratic Risk and Market Friction in Investment Process

Merton (1987) believes that under market friction, where investors pose limitations in access to information, stocks with high idiosyncratic volatility have higher expected return, because investors are not able to decrease company specific risk through diversification.
As in classical point of view, it is assumed that investors are just subject to systematic risk and only mentioned risk will be priced. Based on that view, unsystematic risk completely managed via diversification, while because of information cost and transaction cost in real world, investors hold limited number of stocks in their portfolios. This paper is going to study idiosyncratic risk and return in Tehran Stock Exchange using monotonic relationship. Our findings don’t approve monotonic relationship between expected return of idiosyncratic risk. Furthermore our results show that average return of high idiosyncratic portfolios is greater than low idiosyncratic portfolios.