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Is Idiosyncratic Risk a Source of Momentum?

Recent studies reject the notion that momentum profits are compensation for risk by showing that momentum profits are mostly comprised of idiosyncratic components that cannot be risk (which, according to standard theory, must entail non-diversifiable systematic variation). Recent theoretical papers, however, show that idiosyncratic components of returns (in particular idiosyncratic risk) may affect risk premia. Using EGARCH-M, this paper estimates idiosyncratic risk and idiosyncratic risk premia at the individual security level and shows that idiosyncratic risk premia are responsible for between 70 and 90 percent of momentum profits. A closer examination shows that, although securities in the loser portfolio have higher levels of idiosyncratic risk than those in the winner portfolio (confirming other studies), the idiosyncratic risk premia in the loser portfolio are significantly less than those in the winner portfolio. Further supporting a link between idiosyncratic risk premia and momentum profits, we show that momentum portfolios formed by sorting on past idiosyncratic risk premia (rather than raw returns) generate significantly positive profits.