Does Idiosyncratic Return Volatility Capture Information or Noise?

Abstract

This paper examines the cross-sectional association between earnings quality and firm-specific return volatility for a sample of UK firms listed in the London Stock Exchange. Identifying the determinants of idiosyncratic volatility has been a topical issue since the Campbell et al. (2001) study which documents a noticeable increase in average firm-level volatility across time. Using panel data, we find that poor information environments resulting from poor earnings quality are associated with higher firm-specific return volatility. This finding is consistent with the noise-based approach of firm-specific return volatility. In addition, we provide empirical evidence that such association becomes stronger after combining accruals quality and the dispersion in analysts' forecasts to describe a poor information environment. These findings are likely to contribute to the debate on whether firm-specific return volatility captures more firm-specific information being impounded in stock prices or essentially reflects noise.