R2 and idiosyncratic volatility: Which captures the firm-specific return variation?

Abstract

A growing literature regards R2 and idiosyncratic volatility as interchangeable proxies for firm-specific return variation and examines its relations to information efficiency. However, the question on choosing the appropriate proxy, i.e., R2 or idiosyncratic volatility, is less investigated. This paper provides alternative evidences that R2 and idiosyncratic volatility are not interchangeable with the utilization of a unique short selling mechanism in China. Specifically, we mainly find that 1) R2 is not a satisfied proxy when the information environment for individual firm is improved, while idiosyncratic volatility is a satisfied proxy under the improved information environment; 2) R2 and idiosyncratic volatility are satisfied proxies for firm-specific return variation when the information environment for individual firm is deteriorated. These results also complement the existing literature on figuring out the appropriate proxy for firm-specific return variation under different information environment.