Idiosyncratic Return Research Articles

The Conditional Performance of REIT Stock Repurchases

This paper uses a conditional performance measure to test whether real estate investment trust (REIT) managers announcing stock repurchases have private information about their firms' prospects. We use stock price to condition for public information and measure the managers' implied private information by the covariance between repurchase size and subsequent stock payoffs (or operating performance). Results show that managers have private information but mostly with respect to long-term as opposed to near-term payoffs. We also find that repurchase size is positively related to a stock's idiosyncratic return volatility, perhaps because noisy stocks deviate farther from fundamental value, offering informed managers larger profit potential.

The Limits of Arbitrage: Evidence from Fundamental Value-to-Price Trading Strategies

Shleifer and Vishny (1997) argue that arbitrage can be both costly and risky. As a result, arbitrageurs will not exploit arbitrage opportunities if the costs and risk of arbitrage exceed its benefits, thereby allowing mispricing to survive for long periods of time. Frankel and Lee (1998) document that the fundamental value-to-price (Vf/P) ratio predicts future abnormal returns for up to three years, where Vf is an estimate of fundamental value based on a residual income model that uses analyst earnings forecasts. Ali, Hwang and Trombley (2003a) further show that their results seem consistent with the mispricing explanation rather than with the risk explanation of the Vf/P effect. Thus, the Vf/P effect provides a good means to examine the limits of arbitrage. We find that the Vf/P effect is extremely weak in stocks of old age (measured by the history of listing), low investor sophistication, high divergence of opinion, high idiosyncratic return volatility, and high transaction costs. Further analysis shows that firm age, earnings quality, and divergence of opinion have incremental power beyond other measures of risk in explaining the cross-sectional variation in the Vf/P effect. Our results appear to be consistent with the argument of the limits of arbitrage. More specifically, when arbitrageurs exploit arbitrage opportunities, they seek to avoid mispriced stocks with the greatest arbitrage risk. JEL Classification: G10, G11, G14

Target-Firm Information Asymmetry and Acquirer Returns

We show that acquirer returns are significantly higher in stock-swap acquisitions of difficult-to-value targets, as measured by R&D intensity and idiosyncratic return volatility. This finding contributes to an explanation of the determinants of, and value gains from, using stock as a method of payment. The effects of target-valuation uncertainty on both the method of payment and the market reaction to acquisitions are more likely to be apparent in samples of private acquisitions, and that these effects can be masked in samples of acquisitions of publicly held targets. Nevertheless, our results hold for publicly traded targets in multivariate analysis.

The Information Content of Idiosyncratic Volatility

This paper uses adverse selection in corporate information disclosure to explain a recently documented asset pricing anomaly. Ang, Hodrick, Xing, and Zhang (2006a) show that stocks with high idiosyncratic return volatilities tend to have low future returns. In this paper, we find that idiosyncratic volatility is also inversely related to future earning shocks. More importantly, we show that the return predictive power of idiosyncratic volatility is induced by its information content on future earnings. We provide empirical results to support our explanation that firms with poor prospect of future earnings tend to disclose less information, resulting in a higher degree of heterogeneity in investors beliefs, which in turn leads to higher stock return volatility and trading volume. Further analysis suggests that investors tend to underreact to earnings information in idiosyncratic volatility, and the mispricing of idiosyncratic volatility is inversely related to both investor sophistication and stock liquidity.

Contextual Fundamentals, Models, and Active Management

Applying a multifactor alpha model across a diverse range of stocks is a popular approach to forecast securities' expected returns. This approach assumes that one single return-generating equation provides adequate alpha forecasts - that is, one-size-fits-all. In this paper, we extend prior empirical research by introducing an alternative alpha-modeling approach. Our approach presents a parsimonious way of modeling securities individually in order to capture the idiosyncratic return behavior pertaining to different security contexts. Our investment objective is information ratio maximization, through optimal alpha factor weights. Our modeling technique demonstrates the importance of different factor categories (cheapness, quality, and sentiment) that vary significantly across various security contexts. These contexts span typical dimensions of risk characteristics (value, growth, or earnings variability). We illustrate how practitioners can apply our technique in their security selection process, and document to what extent our approach improves the ex post information ratio when compared with a one-size-fits-all approach.

Limits of Arbitrage and Trading on the Accruals Anomaly: Evidence from Mutual Funds

This paper examines the impact of market frictions on mutual funds' trading on the anomaly. On average, mutual funds are accruals traders who hold and trade towards stocks with low accruals. However, they avoid trading on stocks with extreme accruals, and the gains from actively using the strategy are modest. We provide evidence that transaction costs constrain the use and reduce the profitability of the strategy. Funds with more active trading also have higher idiosyncratic return volatility. However, idiosyncratic risks do not significantly affect fund flows and therefore do not serve as a limit to arbritrage in the sense of Shleifer and Vishny (1997).

Analysts' Incentives to Produce Firm-Specific versus Industry-Level Information: Theory and Evidence

Using stock returns around recommendation changes to measure the information produced by analysts, I find that analysts produce more firm-specific than industry information. Analysts produce more firm-specific information on stocks with higher idiosyncratic return volatilities. The amount of industry information produced by analysts increases with the absolute value of the stock's industry beta and decreases with the stock's idiosyncratic volatility. Other stocks in the industry also respond to the recommendation change, and the magnitude of the response increases with the absolute value of the industry beta of the recommended stock and that of other stocks in the industry. I also offer results on how investors may use analyst research more effectively and potentially improve their investment performance.

Financial Reporting Quality and Idiosyncratic Return Volatility Over the Last Four Decades

Campbell, Lettau, Malkiel and Xu (2001) show that stock returns of individual firms have become more volatile in the U.S. since 1960. We hypothesize and find that deteriorating earnings quality is associated with higher idiosyncratic return volatility over the period 1962-2001. These results are robust to controlling for (i) inter-temporal changes in the disclosure of value-relevant earnings information, sophistication of investors and for the possibility that earnings quality can be informative about future cash flows; (ii) stock return performance, cash flow operating performance, cash flow variability, growth, leverage and firm size; and (iii) accounting for new listings, high technology firms and firm-years with losses, mergers and acquisitions and financial distress.

Have European Stocks Become More Volatile? An Empirical Investigation of Volatilities and Correlations in EMU Equity Markets at the Firm, Industry and Market Level

We examine the dynamics of idiosyncratic risk, market risk and return correlations in European equity markets using weekly observations from 3515 stocks listed in the Euro-area stock markets in the period 1974-2004. Similarly to Campbell, Lettau, Malkiel and Xu (2001), we find an increase in idiosyncratic volatility, implying that it now takes more stocks to diversify away idiosyncratic risk. Contrary to their findings, however, market risk is trended upwards and correlations among the stocks are only mildly trended downwards. Market volatility tends to lead the other volatility measures in EMU markets whereas idiosyncratic volatility leads in the US ones. Both the volatility and the correlation measures increase at times of low market returns implying a skewed market portfolio return distribution. We suggest a number of implications of these findings for portfolio management, trading and asset pricing.

Time-Varying Moments, Idiosyncratic Risk, and an Application to Hot-Issue IPO Aftermarket Returns

This paper proposes time-varying idiosyncratic risk as a component driving conditional abnormal returns and outlines a corresponding Engle et al. (1987) ARCH-M market model. An application is given to initial public offering (IPO) aftermarket stock returns, where a positive relation between idiosyncratic risk and returns is consistent with young issues' equity as a contingent claim on firm assets. The empirical results for an illustrative sample of German Neuer Markt stocks traded during the first two years after initial listing indicate pronounced skewness as well as a positive relation between conditional idiosyncratic risk and expected returns. Conditioning aftermarket performance on risk yields much lower levels of abnormal return significance than a standard approach.

Stock Valuation and Learning about Profitability

AbstractWe develop a simple approach to valuing stocks in the presence of learning about average profitability. The market‐to‐book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firm's lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

Arbitrage risk and the book-to-market anomaly

This paper shows that the book-to-market ( B/M) effect is greater for stocks with higher idiosyncratic return volatility, higher transaction costs, and lower investor sophistication, consistent with the market-mispricing explanation for the anomaly. The B/M effect for high volatility stocks exceeds that for the low volatility stocks in 20 of the 22 sample years. Also, volatility exhibits significant incremental power beyond transaction costs and investor sophistication measures in explaining cross-sectional variation in the B/M effect. These findings are consistent with the Shleifer and Vishny (1997) thesis that risk associated with the volatility of arbitrage returns deters arbitrage activity and is an important reason why the B/M effect exists.

Stock Valuation and Learning About Profitability

We develop a simple approach to valuing stocks in the presence of learning about average profitability. The market-to-book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firm's lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

Forecasting Bankruptcy More Accurately: A Simple Hazard Model

I argue that hazard models are more appropriate than single-period models for forecasting bankruptcy. Single-period models are inconsistent, while hazard models produce consistent estimates. I describe a simple technique for estimating a discrete-time hazard model. I find that about half of the accounting ratios that have been used in previous models are not statistically significant. Moreover, market size, past stock returns, and idiosyncratic returns variability are all strongly related to bankruptcy. I propose a model that uses both accounting ratios and market-driven variables to produce out-of-sample forecasts that are more accurate than those of alternative models. Copyright 2001 by University of Chicago Press.

Why Has Idiosyncratic Volatility Increased?

A very interesting reason to study idiosyncratic volatility is that it may tell us quite a bit about the evolution of the firm's investment and financial policies. The purpose of this essay is to investigate the role of evolving investment and financial policies at the firm level as well as other exogenous variables that shape the volatility of idiosyncratic stock returns. In this regard, the essay targets two questions specifically: 1) What firm level charateristics explain the cross section of firm level volatility? 2) How have exogenous variables that shape firm level volatility evolved?

Reports of beta's death are premature: Evidence from the UK

A number of authors have found that firm size and book-to-market-value capture the cross-sectional variation in average stock returns. More importantly, these variables have been shown to out-perform the CAPM's β coefficient in explaining the cross-section of US stock returns. However, these studies all employ variants of the two-step estimator due to Fama and MacBeth (Fama, E.F., MacBeth, J.D., 1973. Risk, return and equilibrium: Empirical tests. Journal of Political Economy 71, 607–636), which impose implicitly the restriction that idiosyncratic returns are uncorrelated. In this paper we use a one-step estimator due to McElroy et al. (McElroy, M.B., Burmeister, E., Wall, K.D., 1985. Two estimators for the APT model when factors are measured. Economics Letters 19, 271–275) and find a highly significant role for β risk in the UK stock market when we allow for correlation amongst idiosyncratic returns.

Do Assumptions About Factor Structure Matter in Empirical Tests of the APT?

The effect of assumptions about factor structure on empirical tests of multifactor models such as the Arbitrage Pricing Policy Theory has received little attention in the literature. Using data on securities traded on the London Stock Exchange, we examine whether returns are best described by an approximate factor structure and whether assumptions about correlations across idiosyncratic returns have a significant impact on estimated prices of risk and their significance. Our findings suggest that returns are best described by an approximate factor structure and, if this is taken into account when empirically testing the APT, six factors carry significant prices of risk. However, if a strict factor structure is imposed, no factors carry significant prices of risk. These findings suggest that assumptions about factor structure matter in empirically testing the APT.

Capacitated Location Problems on a Line

This paper examines capacitated facility location problems on a straight line. To serve a customer, a facility must be located within a corresponding customer neighborhood. The fixed costs of locating facilities and the unit production costs of serving a customer from a facility can depend upon their locations on the line. We discuss the computational complexity of several capacitated location models. For capacitated problems on a line with non-nested customer intervals, and for general capacitated problems that satisfy a certain “monotonicity” property, we develop polynomial-time dynamic programming algorithms for (i) locating minimum cost facilities to serve all customers, and (ii) maximizing the profit by locating up to q facilities that serve some or all customers with idiosyncratic returns, penalties and demands.

The Economic Function of Underfunded Pension Plans

The Economic Function of Underfunded Pension Plans