Idiosyncratic Return Volatility Research Articles

ESG rating disagreement and idiosyncratic return volatility: Evidence from China

Following the increasing importance of sustainable development and the popularity of ESG investing activities, ESG ratings have grown to be crucial references for investors’ decision-making. However, there are substantial disagreements among different rating agencies. This study examines the impact of ESG rating disagreement on idiosyncratic return volatility using data from five prominent rating agencies: SynTao Green Finance, Huazheng, Hexun, Bloomberg, and Rankins ESG Ratings. The findings suggest that ESG rating disagreement will increase idiosyncratic return volatility. This relation is driven by investor attention and noise trading. Heterogeneity tests reveal that the higher analyst coverage and greater analyst forecast bias, the more pronounced the impact of ESG rating disagreement on idiosyncratic return volatility. While firms with foreign investors and more institutional investors can alleviate the interference.

Strategic deviation and idiosyncratic return volatility

This study examines the relationship between strategic deviation and idiosyncratic return volatility (IRV). Using a large sample of U.S. public firms, we find that firms that strategically deviate from industry peers are related to higher IRV. This relationship is weaker for firms with transparent information environments and better corporate governance. Robustness tests show that our results are not affected by endogeneity problems. Additional analyses reveal that strategically deviant firms are associated with higher earnings volatility and cash flow volatility. Taken together, we reveal that strategic deviation has important implications for firms’ risk.

Real earnings management and idiosyncratic return volatility

PurposeHigher real earnings management (REM) reduces financial reporting quality and increases the uncertainty of future cash flows and profitability among investors. This study asserts that REM-induced noise increases idiosyncratic return volatility (IVOL), aims to examine the association between REM and IVOL and further investigates whether information asymmetry, firm life cycle and economic policy uncertainty (EPU) moderate the association between REM and IVOL.Design/methodology/approachThe authors use 94,445 firm-year observations from the US over 1987 to 2019 and test this study’s hypotheses using ordinary least square regressions with robust standard errors clustered by firm. The authors use change analysis, two-stage models and the impact threshold of the confounding variable analysis to address endogeneity.FindingsThe authors find that REM increases IVOL. This positive association is more pronounced for firms with more information asymmetry, for firms in the mature stage of the life cycle, compared with their growth-stage counterparts; and during periods of high EPU.Originality/valueExtant research suggests that accrual manipulation increases IVOL. However, the shift from accrual manipulation to REM and the managerial preference towards REM suggests that it is important to explore the impact of REM on IVOL. Thus, the authors enhance the understanding of the impact of earnings management on IVOL by documenting that REM-induced noise increases IVOL. The authors further extend the limited research on the consequences of REM and report an adverse consequence.

Voluntary CEO turnover, online information, and idiosyncratic volatility

CEO turnover, whether voluntary or forced, affects corporate decisions. This study investigates the relationship between voluntary CEO turnover and idiosyncratic return volatility, as well as the influence of online information on this relationship. We find that voluntary CEO turnover leads to higher idiosyncratic volatility, the volume and positive tone of online information can mitigate the positive effect, while negative tone fails to do so. Additional analysis shows that voluntary CEO turnover increases noise trading, whereas online information decreases noise trading, verifying the non-information view in China's stock market.

Toxic chemical releases and idiosyncratic return volatility: A prospect theory perspective

AbstractWe investigated whether and how firms’ toxic chemical releases (TCRs) affect idiosyncratic return volatility (IRV) using a prospect theory lens. Utilising a large sample of US public listed firms over the period 2001–2018, we find a significant and positive association between TCRs and IRV, suggesting that firms releasing more toxic chemicals have higher IRV. Additional analyses show that a positive association between TCR and IRV is more evident among firms with (i) high revenue, (ii) lower financial constraints and (iii) fewer environmental violations. A further test also suggests that a positive association between TCRs and IRV is contingent on political leadership ideology and market states. Our results remain consistent with weighted TCRs, IRV based on the Fama–French three‐factor model, fixed‐effect two‐stage least square estimator (FE‐2SLS), and other robustness checks. These findings shed light on the role of equity markets as a driver for capital‐intensive pollution abatement activities and enhanced compliance with environmental laws, standards and best practices.

Idiosyncratic return volatility and the role of firm fundamentals: A cross-country analysis

We investigate the relation between fundamental idiosyncratic volatility and stock returns idiosyncratic volatility using data from 56 countries. We find a strong positive relation between fundamental idiosyncratic volatility and idiosyncratic volatility of returns. This association, however, seems to be entirely concentrated in the developed economies, and we find no effect in the emerging markets. Specifically, fundamental idiosyncratic volatility does not lead to more idiosyncratic return volatility in countries with poor legal institutions and weak shareholder protection laws.

Firm age and realized idiosyncratic return volatility in China: The role of short-sales constraints

This paper investigates how realized idiosyncratic return volatility changes with firm age in the Chinese stock market. By employing a sample of 26,676 firm-year observations of 2798 A-share listed Chinese firms from 2001 to 2019, we find that realized idiosyncratic return volatility is negatively associated with firm age. Further, we find that loosening short-sales constraints strengthens this negative association, and that heterogeneity of investor beliefs is the most likely mechanism driving the negative relation, rather than the alternative explanations of cash flow volatility and growth options. Our results are fairly consistent under two different measures of firm age, and are robust to a choice of two multiple-factor models (the Fama-French three-factor and five-factor models) as well as two data frequencies (daily and monthly) used to estimate realized idiosyncratic return volatility.

Idiosyncratic Return Volatility and the Role of Firm Fundamentals: A Cross-Country Analysis

We investigate the relation between fundamental idiosyncratic volatility and stock returns idiosyncratic volatility using data from 56 countries over 1980-2014. We find a strong positive relation between fundamental idiosyncratic volatility and idiosyncratic volatility of returns. This association, however, seems to be entirely concentrated in the developed economies and we find no effect in the emerging markets. Specifically, fundamental idiosyncratic volatility does not lead to more idiosyncratic return volatility in countries with poor legal institutions and weak shareholder protection laws.

Total Factor Productivity and Idiosyncratic Volatility Trends

Firms’ idiosyncratic stock return volatility has become more volatile in the US since the 1960s. This paper investigates why individual stocks became more volatile over the 1964–2013 period using firm-level total factor productivity (TFP). On average, the volatility of idiosyncratic TFP growth rate has increased, being associated with higher idiosyncratic return volatility. The connection between TFP growth and economic profits provides an explanation for the increase in the idiosyncratic volatility of fundamental cash flows. The results are robust when using time-series and panel regressions and controlling for cash flow and earnings variability, size, book-to-market, leverage, profitability, age, dividend yield, and stock illiquidity.

Bond Volatility and CDS Auctions

We document a higher bond return volatility around the time of default for bonds included in CDS auctions (especially cheapest-to-deliver bonds) versus those that are not, while controlling for firm fundamentals and bond illiquidity. This finding does not extend to time periods far ahead of default, and there is no significant difference between the idiosyncratic stock return volatility of CDS firms and non-CDS firms around the time of default. These results are more consistent with CDS buyers and sellers manipulating bond prices to achieve favorable CDS auction outcomes, rather than a spillover of price discovery by CDS traders into the stock and bond markets.

Financial Statement Comparability and Idiosyncratic Return Volatility

AbstractThis study examines the association between financial statement comparability and idiosyncratic return volatility (IRV). A greater degree of comparability lowers information acquisition costs, reduces the uncertainties associated with performance evaluation, and increases the overall quantity and quality of information available to corporate outsiders, which, in turn, helps investors to understand and evaluate the cash flow and performance of firms more accurately. Therefore, we hypothesize a negative association between financial statement comparability and IRV. Using a large US sample from 1981 to 2013, we show that financial statement comparability is associated with lower level of IRV significantly. We also find this association to be more pronounced in a poor information environment. This study contributes to the emerging research that stresses the benefits of financial statement comparability.

Idiosyncratic Return Volatility, Uncertainty, and Asset Pricing Implications

In this study, we decompose idiosyncratic stock return volatility (IVOL) into uncertainty and residual volatility, and find that the negative IVOL-return relation primarily comes from the uncertainty component. Further analysis indicates that firm uncertainty increases are associated with negative contemporaneous stock returns. High uncertainty firms also have lower firm values and higher expected returns, and exhibit more asymmetric price responses to good/bad market states. All of these are consistent with ambiguity aversion modeled by Epstein and Schneider (2008). Our study documents novel valuation and return patterns associated with the uncertainty content embedded in IVOL. Our findings suggest that uncertainty offers a new channel to explore the IVOL puzzle. It may also help interpret the common factor in IVOL documented in the recent literature.

The Determinants of Idiosyncratic Volatility

We investigate the cross-sectional and time-series determinants of idiosyncratic volatility in the Korean market. In particular, we focus on the empirical relation between firms’ asset growth rate and idiosyncratic stock return volatility. We find that, in the cross-section, companies with high idiosyncratic volatility tend to be small and highly leveraged, have high variance of ROE and Market to Book ratio, high turnover rate, and pay no dividends. Furthermore, firms with extreme (either high positive or negative) asset growth rates have high idiosyncratic return volatility than firms with moderate growth rates, suggesting the V-shaped relation between asset growth rate and idiosyncratic return volatility. We find that the V-shaped relation is robust even after controlling for other factors. In time-series, we find that firm-level idiosyncratic volatility is positively related to the dispersion of the cross-sectional asset growth rates. As a result, this study is contributed to show that the asset growth is the most important predictor of firm-level idiosyncratic return volatility in both the cross-section and the time-series in the Korean stock market. In addition, we show how the effect of risk factors varies with industries.

Does High‐Quality Auditing Mitigate or Encourage Private Information Collection?

AbstractThe finance literature offers two competing possibilities on how investors respond to the quality of public financial statements in their pricing decisions. They could collect either (i) more private information to benefit from lower information collection cost, or (ii) less private information because of lower incremental benefits. In this paper, we use the audit setting to examine which possibility prevails. Using the idiosyncratic return volatility as a proxy for firm‐specific information, we show in a sample of 51,559 firm‐year observations for 8,261 U.S. firms spanning the period of 2000–2010 that firms audited by higher‐quality auditors exhibit lower average idiosyncratic return volatility but a higher concentration of it at the time of earnings announcements. Our findings are consistent with the argument that investors reduce private information collection in response to higher audit quality. Our findings are robust to alternative measures of audit quality and idiosyncratic return volatility.

Social capital and idiosyncratic return volatility

We examine whether regional social capital has any impact on idiosyncratic return volatility. Using US data, we find that firms headquartered in high social capital counties exhibit significantly lower idiosyncratic return volatility. This effect is more pronounced in the presence of financial reporting quality and corporate social responsibility. When we estimate the direct and indirect effects of social capital, our study reveals that the direct effect of social capital captures around 80% of the total effect. These findings suggest that firm-specific variables do not explain all of a firm’s idiosyncratic return volatility, but regional social capital also plays a role. JEL classification: G10, G12, G30, M14

The Effect of Customer Concentration on CEO Risk-Taking Incentives

This paper examines the effect of customer base concentration (“CC”), which captures the extent to which sales to major customers account for a supplier’s total annual revenue, on the supplying firm’s CEO risk-taking equity incentives. Existing literature predominantly uses total annual revenue as a proxy for firm size or managerial decision difficulty without examining from whom the revenue is earned. My paper improves this design by decomposing total annual revenue into revenue from major customers and revenue from the rest based on the CC concept posited by Patatoukas (2012). As prior literature shows CC risk to be idiosyncratic (Dhaliwal et al., 2013) and modern risk-based asset pricing theories posit that idiosyncratic return volatility is not priced amongst the risk-neutral investors, CC risk is diversifiable at the shareholder level – hence, only the performance-related net-benefits (Patatoukas, 2012) of engaging in contractual relationships with a few major customers should determine the desirability of high CC for the risk-neutral investors. However, in the midst of deficient accommodation, a risk-averse, undiversified manager may exhibit risk-aversion towards the state of high CC. Thus, I expect the BOD to recognize this potential agency problem and provide more risk-taking incentives for a CEO who manages a highly concentrated customer base. Upon empirical investigation, I document that CC exerts a positive influence over the supplier’s CEO vega incentives, whereby the CEO is compensated for assuming additional CC risk as her equity wealth becomes an increasing function of the firm’s stock return volatility. Furthermore, I show that less risk-taking incentives are expected when the degree of product substitution difficulty is high or the supplier’s trade credit levels are low, illustrating that the predictability of CC over CEO equity incentives varies with the settings in which the suppliers and customers interact.

Social Capital and Idiosyncratic Return Volatility

We examine whether regional social capital has any impact on idiosyncratic return volatility. Using US data, we find that firms headquartered in high social capital counties exhibit significantly lower idiosyncratic return volatility. This effect is more pronounced in the presence of financial reporting quality and corporate social responsibility. When we estimate the direct and indirect effects of social capital, our study reveals that the direct effect of social capital captures around 80% of the total effect. These findings suggest that firm-specific variables do not explain all of a firm’s idiosyncratic return volatility, but regional social capital also plays a role.

Strategic growth option, uncertainty, and R&D investment

This paper investigates the effect of uncertainty on R&D investment. We find that firms invest more in R&D when they face higher uncertainty, as measured by idiosyncratic return volatility. We further show that the effect is more pronounced for firms in more competitive industries as well as for firms whose products have less market power. Overall, our findings support the theory of strategic growth option in which firms under competition follow preemptive strategy when they face high uncertainty.

Market Efficiency with Micro and Macro Information

We propose a tractable, multi-security model in which investors choose to acquire information about macro or micro fundamentals or remain uninformed. The model is solvable in closed form and yields a rich set of empirical predictions. Primary among these is an endogenous bias toward micro efficiency. A positive fraction of agents will always choose to be micro informed, but in some cases no agent will choose to be macro informed. Furthermore, for most reasonable choices of parameter values, prices will be more informative about micro than macro fundamentals. A key driver of our results is that only micro informed investors take the other side of idiosyncratic noise trading in individual stocks. We explore the model’s implications for systematic and idiosyncratic return volatility and trading volume, for excess covariance and volatility, and for the cyclicality of investor information choices.

The Accounting Treatment of Goodwill, Idiosyncratic Risk, and Market Pricing

We study the relationship between goodwill and future returns by considering how the information content of goodwill before and after Statement of Financial Accounting Standards (SFAS) 142 affects idiosyncratic return volatility ( IVOL). Contrary to expectations, previous research has documented that stocks with high IVOL have low future returns ( IVOL anomaly). We build on research that shows that high IVOL is a function of low information on future earnings and define goodwill as a growth option that could be priced through IVOL. Our results show that, during the goodwill amortization period, IVOL is high and the IVOL anomaly is strong. In contrast, nonamortized and tested for impairment goodwill is informative and corrects the IVOL anomaly. We find evidence that SFAS 142’s recognition of goodwill as an asset with indefinite useful life results in value-relevant information about firm growth options and future earnings, thus reducing IVOL, eliminating the IVOL anomaly, and creating an environment of more efficient market pricing of risk.