Idiosyncratic Stock Returns Research Articles

Cost uniqueness and information uncertainty

AbstractPrior literature has studied firm uniqueness and its implications for capital market participants by investigating earnings uniqueness. We recognize that cost and revenue uniqueness provide separate insights about firm uniqueness because different forces drive firm‐specific revenues and costs. Cost uniqueness is of special interest because costs are opaque to investors and more complex than revenues. Therefore, we examine how cost uniqueness affects information uncertainty from the perspective of external participants. We find that idiosyncratic stock return volatility increases with cost uniqueness independently and incrementally from revenue uniqueness. We validate these results with several cross‐sectional tests that provide insights into the forces that drive the association between information uncertainty and cost uniqueness. In addition, we find that higher cost uniqueness is associated with finer cost disclosure. Overall, we show that cost uniqueness is an important dimension of cost behavior that is linked to strategic decision‐making and affects uncertainty surrounding firm valuation.

Extremal quantiles and stock price crashes

We employ extreme value theory to identify stock price crashes, featuring low-probability events that produce large, idiosyncratic negative outliers in the conditional distribution. Traditional methods employ approximations under Gaussian assumptions and central moments. This is inherently imprecise and susceptible to misspecifications, especially for tail events. We instead propose new definitions and measures for crash risk based on conditional extremal quantiles (CEQ) of idiosyncratic stock returns. CEQ provide information on quantile-specific impact of covariates, and shed light on prior empirical puzzles and shortcomings in identifying crashes. Additionally, to capture the magnitude of crashes, we provide an expected shortfall analysis of the losses due to crash. Our findings have important implications for a burgeoning literature in financial economics that relies on traditional approximations.

Do derivatives benefit shareholders? Evidence from India

We show that for a sample of 1,882 publicly listed Indian firms and sample period from 2016 to 2021, derivative-usage significantly reduces the idiosyncratic stock return volatility. The negative effect of derivative-usage on idiosyncratic volatility is more pronounced for firms with poor information environment, and financially-constrained and distressed firms. The quality of corporate governance does not influence the relationship between derivative-usage and firm risk. The valuation of derivative-user firms is significantly higher than that of non-derivative-user firms. Overall, using derivatives benefits the firms using them, both in terms of reducing risk and creating value for the shareholders.

Idiosyncrasy as a Leading Indicator

AbstractDisequilibrating macro shocks affect different firms’ prospects differently, increasing idiosyncratic variation in forward-looking stock returns before affecting economic growth. Consistent with most such shocks from 1947 to 2020 enhancing productivity, increased idiosyncratic stock return variation forecasts next-quarter real GDP growth, industrial production growth, and consumption growth both in-sample and out-of-sample. These effects persist after controlling for other leading economic indicators.

Product market competition and stock return dependence

We model the spillover effect between competing firms’ daily idiosyncratic stock returns, using spatial econometric techniques. Contagion effect from rival firms dominates competitive effect, and the net effect is larger from negative return shocks of rival firms than from positive ones. The net effect is strong for firms in product markets with low concentration and high product market fluidity.

The stock market tips

We investigate the influence of public companies on their local economies through the spending of their employees on local goods and services. Using the taxicab industry in New York City as a laboratory, we find that tips paid for taxis taken near firms’ headquarters are higher on the days the firms’ stock returns are higher. This effect is short-lived, is stronger for firms offering greater stock-based compensation, and varies across industries. In addition, tipping increases gradually following the initial public offerings (IPOs) of firms, and this increase becomes significant at the end of the IPO lock-up period. Idiosyncratic stock returns are more strongly associated with tipping than are aggregate stock market or industry returns, suggesting that the increase in tipping with stock returns is due to firm-level factors. The number of taxis taken near firms’ headquarters, too, increases with their stock returns. Additional tests suggest that these findings are non-spurious.

The CDS market reaction to loan renegotiation announcements

This paper investigates the impact of loan renegotiations on firms’ credit risk using the CDS market as a measure of credit risk. Using a sample of public US firms for 2010–2017, we document a significant decrease in CDS spreads and returns that we interpret as evidence of a certification effect. The finding suggests that the loan renegotiations are on average beneficial for the firm. The strongest reactions are for material amendments such as line of credit amount or tranche amount. Additionally, we find negative stock market returns, although barely statistically significant. Moreover, we identify an anticipation effect of up to 30 days before the announcement date on the CDS market, possibly due to informed trading by CDS banks of their speculative-rated borrowers’ CDS contracts. Finally, we show that firm-specific CDS returns lead idiosyncratic stock returns, especially around the announcement date and for speculative-rated firms.

Policy uncertainty and peer effects: Evidence from corporate investment in China

This study investigates whether economic policy uncertainty (EPU) magnifies peer effects in corporate investment in China and the economic mechanisms through which EPU may act upon this property. We examine this relationship by analysing a large sample of publicly listed companies in China for the period of 2009–2019, adopting the peer-firm-average idiosyncratic stock return to capture exogenous variations in peer firms’ investment activities. We demonstrate that peer effects are stronger when EPU is increasing in intensity. We also find that high EPU magnifies peer effects by decreasing the accuracy of firms’ signals regarding their investment opportunities, asymmetrically impacting their capacity to acquire information and exacerbating managers’ career concerns. We further show that increased EPU magnifies peer effects only for underinvesting firms, causing underinvestment to persist and retarding recovery from an economic downturn. Our investigation provides original evidence of how EPU influences corporate investment decisions through peer effects, contributing to the continuing debate on the role of EPU and corporate investment efficiency by establishing that the adoption of consistent and transparent economic policies optimize returns on a company’s investments, especially during an economic downturn.

Tax aggressiveness and idiosyncratic volatility

This study finds that aggressive tax strategies adopted by a firm affect idiosyncratic stock return volatility. Aggressive tax strategies, which I measure as tax paid by a firm divided by pretax income (adjusted for special items), are associated with higher levels of idiosyncratic stock volatility. Uncertainty associated with tax strategies may result due to several factors, such as penalties, fines, and additional tax payments if particular tax strategies are disallowed by taxation authorities, or if there are changes in tax rules. Such uncertainty affects the future cash flows of a firm and is reflected in more volatile stock returns. Financial constraints, corporate governance mechanisms, and information environments surrounding a firm influence the relation between idiosyncratic volatility and effective tax rates.

Research on the Relationship between Trade Volatility, Property Rights and New Energy Stock Returns under the Background of New Energy Industry Development

The research on the relationship between risk and return of new energy stocks is the focus of financial research. Related research focuses more on the relationship between idiosyncratic fluctuation risk and stock returns. In the Chinese stock market, some Chinese investors clearly prefer stocks with high risk characteristics, which leads to overvalued stocks. However, the short-selling restrictions in the Chinese stock market and the heterogeneity of investors have also led to a significant negative correlation between idiosyncratic volatility and cross-sectional yield. There are many studies on the relationship between idiosyncratic volatility and stock returns, but no consistent conclusions have been drawn, and there is a lack of relevant research on new energy stocks. Therefore. This paper collates the data of 70 listed companies in the new energy and new energy automobile industry from 2017 to 2019, tracks the stock returns of sample companies for 3 years (36 months), and conducts in-depth research on the relationship between idiosyncratic fluctuation risks and new energy stock returns. To further verify and supplement the risk-return relationship of China's new energy stock market and provide a certain basis for the company's decision-making behaviour.

Business groups and the incorporation of firm-specific shocks into stock prices

Firm-specific information has a damped effect on business group-affiliated firms’ stock prices. Such firms’ idiosyncratic stock returns are less responsive to idiosyncratic commodity price shocks than are the idiosyncratic returns of otherwise similar unaffiliated firms in the same country and commodity-sensitive industry. Using global commodity shocks means we assess responses to common idiosyncratic shocks of the same magnitude, frequency, and observability. Further identification follows from difference-in-difference tests exploiting successful and matched exogenously failed control block transactions. We conclude that business group firms’ stock prices provide less firm-specific information to capital providers and managers.

The impact of economic policy uncertainty on stock returns: The role of corporate environmental responsibility engagement

AbstractThis paper examines the impact of economic policy uncertainty (EPU) on market‐driven common stock returns and individual‐driven idiosyncratic stock returns as well as explores the role of corporate environmental responsibility (CER) engagement on this impact based on a sample of 175 firms listed on Shanghai and Shenzhen 300 index from 2008 to 2016. The results show that an increase in EPU significantly reduces the market‐driven common stock returns but increases individual‐driven idiosyncratic stock returns. Further, EPU has a lower negative impact on the common stock returns of high‐CER firms comparing with low‐CER firms. EPU has a higher positive impact on idiosyncratic stock returns of high‐CER firms comparing with low‐CER firms. Overall, the findings of this paper extremely relevant for the government, investors and firm's managers and can be utilised for policy and investment decision‐making.

The Stock Market Tips

We investigate the influence of public companies on their local economies through the spending of their employees on local goods and services. Using the taxicab industry in New York City as a laboratory, we find that tips paid for taxis taken near firms’ headquarters are higher on the days their stock returns are higher. This finding is stronger for firms offering greater stock-based compensation, and tipping also increases following the initial public offerings (IPOs) of firms particularly at the end of the IPO lock-up period. Idiosyncratic stock returns are more strongly associated with tipping than are aggregate stock market returns, suggesting that the increase in tipping with stock returns is due to firm-level factors. The number of taxis taken near firms’ headquarters, too, increases with their stock returns. Additional tests suggest that these findings are non-spurious.

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.

Incentive‐compatible contracts in merger negotiations: The role of acquirer idiosyncratic stock return volatility

AbstractWe show that the acquiring firm's idiosyncratic stock return volatility (sigma) is an important determinant of the selection and perceived valuation effects of earnouts in Mergers and Acquisitions (M&As). Earnout‐based M&As are more often announced by high‐sigma acquirers (nearly 40% of all earnout‐based M&As), yet the documented higher risk‐adjusted returns accrued to acquirers in earnout‐based M&As, relative to M&As settled in cash, stock or mixed payments (the earnout effect), appear in deals announced by low‐sigma acquirers (nearly 20% of all earnout‐based M&As). High‐sigma acquirers employing earnouts appear to break even, or even experience losses, relative to their counterparts employing single up‐front payments. These results are confirmed based on a quasi‐experimental design through which the earnout effect is measured in isolation. We argue that in M&As announced by high‐sigma acquirers, the earnout effect is potentially elusive due to the presence of an acquirer‐specific information revelation effect, resulting from the heightened extent of information asymmetry between (small) acquirers’ managers and outside investors. On the contrary, the use of earnouts in M&As announced by low‐sigma (large) acquirers, whereby the acquirer‐specific information revelation effect is likely negligible, sends a strong signal for value creation that also prevents investors from inducing a size‐related discount.

The Idiosyncratic Volatility Anomaly and the Resale Option in Chinese Stock Market

The well-documented negative association between idiosyncratic volatility (IV) and stock returns is puzzling if investors are risk-averse. We show that this anomaly is also prominent in the Chinese stock market. We attempt to explain the IV anomaly by using the key theories suggested by the literature, such as the lottery effect, arbitrage asymmetry, prospect theory, return reversals and more. None of these competing theories is able to justify the IV anomaly in China. Given that the Chinese stock market possesses both short selling constraints and heterogeneous beliefs, we employ resale option theory as a way to explain the IV puzzle. We find that the resale option value is consistently related to the IV effect in China, and that the explanatory power of the resale option value for the IV anomaly survives a range of robustness tests.

Heterogeneous effects of the SEC’s Securities Offering Reform

The SEC’s Securities Offering Reform (SOR) was intended to address information problems prior to Seasoned Equity Offerings (SEO), thereby mitigating the problem of SEO overpricing. Consistent with the propensity of overpricing increasing with idiosyncratic stock return volatility (IVOL), we find greater capital market benefits from SOR for high IVOL issuers. Counter to concerns that SOR also enables issuers to hype their stock, we find no evidence of market conditioning following SOR, even among high IVOL issuers.

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.

Idiosyncratic volatility and cash flow volatility: New evidence from S&P 500

Employing firm-level data of S&P 500 constituent companies from 1990 to 2016, we offer new evidence on the strong time series and cross-sectional relationships between Idiosyncratic stock return volatility (Ivol) and cash flow volatility even after controlling for illiquidity and firm size, which also vary by period of economic condition. Our results show that Ivol is well explained by the volatility of the three components of DuPont ROE. Aggregate asset turnover volatility alone explains 81.8% of the time series variation of aggregate Ivol, and all independent variables explain 94.7% of the aggregate Ivol. While profit margin volatility and asset turnover volatility have significant relationships with Ivol during the sample period, the volatility of equity multiplier shows significance during the two recession periods in early and late 2000s.