In Merton (1987), idiosyncratic risk is priced in equilibrium
as a consequence of incomplete diversification. We modify
his model to allow the degree of diversification to vary with
average idiosyncratic volatility. This simple recognition
results in a state-dependent idiosyncratic risk premium that
is higher when average idiosyncratic volatility is low, and
vice versa. The data appear to be consistent with a positive
state-dependent premium for idiosyncratic risk both in the
US and in other developed markets.