Essays on idiosyncratic stock return volatility and bank lending incentives

Abstract

This dissertation studies two topics in finance. The first topic is on the firmlevel stock return volatility. The second one is on lending incentives of banks. Chapter 2 studies idiosyncratic stock return volatility in an investment model with convex capital adjustment costs. The model has two predictions: (1) in the cross-section, idiosyncratic return volatility has a V-shaped relationship with the asset growth rate; (2) in the time series, dispersion across firms in asset growth rates positively predicts average idiosyncratic volatility. Two sources of uncertainty drive the cross-sectional V-shape. Specifically, shocks to expected cash flows cause the high return volatility of high growth firms, while innovations to unexpected cash flows lead to the high return volatility of low (negative) growth firms. The time series prediction follows from the cross-sectional V-shape pattern. I document strong empirical support for the model’s predictions of the relationship between the asset growth rate and idiosyncratic return volatility in both the cross-section and time series. Chapter 3 provides explanations to two important questions that arise from the recent financial crisis: (i) Why don’t banks keep enough cash to meet potential liquidity shocks and hence avoid fire sales of illiquid assets? (ii) Why do banks keep a large amount of cash on their balance sheet without lending after large capital injections from the government? This chapter examines both questions in a single framework by considering the lending incentives of banks when facing the risk of liquidity shocks. Banks make decisions based on the tradeoff between costs (fire sales of illiquid assets) and benefits (high returns from bank loans) of