Lower Idiosyncratic Risk Research Articles

Bank-affiliated directors' monitoring, earnings management, and financial reporting quality in emerging markets: Evidence from India

In this novel investigation of creditor governance in an emerging market, this paper examines the monitoring by Indian lenders of firms' earnings management and financial reporting quality through the appointment of a bank-affiliated director to the borrower's board. Specifically, we study the effect of having a bank-affiliated director on the board (a “BDB”), prior to the implementation of India's Insolvency and Bankruptcy Code (IBC). This setting represents a business environment characterized by underdeveloped financial institutions, a weak legal system, and inefficient bankruptcy resolutions. Unlike the U.S., where BDBs play a limited monitoring role, our evidence suggests bank-affiliated directors played an active role in firm governance and lowered earnings management as well as improving financial reporting quality in India during the period of our study. Specifically, we find lower discretionary accruals among firms with BDBs in cross-sectional, pre-post, performance matched, and propensity score matched analyses – signaling higher reporting quality and less earnings management. This finding holds after controlling for endogeneity and when measures of accounting conservatism or earnings persistence are utilized as additional measures of reporting quality. Further, the dampening effect of BDBs on discretionary accruals is more pronounced for companies subject to greater information asymmetry and those prone to agency problems. In addition, firms with BDBs on the board have less volatile ROAs and lower idiosyncratic risk, consistent with BDBs encouraging borrowers to pursue less risky investments to safeguard creditors' interests. As the first examination of the monitoring influence of BDBs on financial reporting quality – and earnings management in particular – in an emerging market, our results provide unique insights for policymakers and creditors seeking to enhance governance and reporting quality of firms in evolving business environments.

A model of managerial compensation, firm leverage and credit stimulus

We study a model in which leverage and compensation are both choice variables for the firm and borrowing spreads are endogenous. First, we analyze the correlation between leverage and variable compensation. We show that allowing for endogenous compensation and leverage can explain the conflicting findings of the empirical literature. We uncover a new channel of complementarity between effort and leverage that induces a correlation sign opposite to what current theoretical models predict. Second, we study the dynamics of leverage and compensation design after a credit stimulus. We derive a set of new empirical predictions. For outward-shifts in credit supply, variable compensation is increasing in leverage growth. Moreover, variable compensation increases after the credit stimulus, especially for firms with low idiosyncratic risk.

Financial materiality and corporate risk: Evidence from an Instrumental Variables (IV) design

This article investigates how the disclosure of financially material information relates to corporate risk. Studying a sample of 18,207 firm-year observations from 27 countries and using the SASB materiality framework, I find evidence that firms with higher disclosure scores of financially material items show lower standard deviation of stock returns and lower idiosyncratic risk. Moreover, I explore an instrumental variables (IV) design and find that the disclosure of financially material items reduces total risk but not idiosyncratic risk. This research contributes to the current debate on whether the disclosure of material items affects corporate prospects.

The pricing of jump and diffusive risks in the cross-section of cryptocurrency returns

In this study, we investigate the pricing of risks in the cross-section of cryptocurrency returns. In doing so, we decompose total variations into systematic and idiosyncratic components, as well as differentiate jumps from diffusive variations. We show that a hedged portfolio sorted on idiosyncratic diffusive risk yields a weekly return of -1.11%, suggesting the existence of a low idiosyncratic risk anomaly. Subsequently, we examine explanations for this anomaly, and show that limits to arbitrage prevent arbitrageurs from fully correcting the mispricing.

Weathering the crash: Do customer-company relationships pay off during economic crises?

The online version contains supplementary material available at 10.1007/s11747-023-00947-1.

Determinants of idiosyncratic risk: evidence from BRICS countries

PurposeThis study examines the determinants of idiosyncratic risk (IR) or unsystematic risk. The study also examines the determinants of IR by dividing the firms into different categories: beta-based firms, liquid and illiquid firms and financially constrained (FC) and unconstrained (FUC) firms.Design/methodology/approachThe fixed effects static panel data model specifications are formulated based on Hausman (1978) test for BRICS (Brazil, Russia, India, China, and South Africa) member countries over the period 2000–2019. Moreover, the t-test is applied to see whether the returns of different types of portfolios are significantly different.FindingsThe portfolio analysis results show that, on average, high IR firms tend to be small in size, highly leveraged, have low competitiveness, low profitability, less dividend yield and low returns for all the sampled countries. The sample paired t-test also confirms that a significant difference exists between extreme portfolios: small and large size and low IR and high IR portfolios. The panel regression results show that firm size, market power, price-to-earnings ratio, return on equity (ROE) and dividend yield negatively relates to IR. Yet, both leverage and liquidity are positively related to IR. However, the sign of momentum returns is mostly positive for the entire sample. The coefficient values for high-beta, FC and illiquid firms are more significant and large than the firms' counterparts for all BRICS member countries. These results support the hypothesis of an under-diversified portfolio and suggest that the above-mentioned firm-specific variables are the significant determinants of unsystematic risk.Practical implicationsThe securities exchange commission, as the supervisor of the public limited companies, needs to increase its role in investor protection related to the uncertainty of investment in the capital market. Accordingly, in making investment decisions in a stock exchange, investors can use the information that captures unsystematic risk for investment decision-making.Originality/valueThis study is the first to explore the determinants of IR in top emerging countries. Second, none of the existing studies has focused on the determinants of the IR based on different categories of firms.

The Performance of Environmental and Social Activities in a Crisis

The financial crisis induced by covid-19 pandemic presents a unique exogenous setting to test the relationship between corporate social responsibility (CSR) and corporate financial performance (CFP). We analyze this relationship in the travel and leisure industry, being the most affected during this period, using both stock returns and risk measures. Consistent with stakeholder salience theory, our results suggest that the effect of CSR activities on financial performance depends on the salience of the stakeholders involved. Firms that invest more in activities that benefit the most salient stakeholders (i.e., customers and the environment) have higher stock returns and lower idiosyncratic risk. On the contrary, pre-crisis investments in human rights actions and community engagement are negatively related to firm value. Moreover, we find a concave relationship between CSR and CFP suggesting an optimal level of CSR. These two results provide an explanation for the mixed findings in the literature, in fact, when we exclude the two hypotheses of a contingent and non-linear relationship, we find a neutral relationship, consistent with recent articles

Does Form 20-F reconciliation elimination for IFRS filers affect the risk forecasting ability of accounting numbers?

This study investigates the effect of the elimination of Form 20-F reconciliation items on the risk relevance of accounting information. Using a sample of U.S. companies and American depositary receipts adopting domestic standards that are generally in accordance or fully compliant with IFRS, this paper finds that IFRS better reflect macroeconomic fluctuations after Form 20-F reconciliation elimination. This paper also finds that Form 20-F reconciliation elimination has no negative effect on the usefulness of accounting data under IFRS in the formulation of superior risk forecasts. Further, this paper finds that the elimination of Form 20-F reconciliation items is associated with lower idiosyncratic risk. Overall, the findings indicate some benefits from Form 20-F reconciliation elimination.

Political Corruption and Corporate Risk-Taking

We use variation in corruption convictions across judicial districts in the US to examine the relationship between political corruption and risk-taking of public firms. Firms headquartered in regions with high levels of political corruption have lower total risk and lower idiosyncratic risk on average. Further analysis shows that corruption tends to encourage firms to pursue risk-decreasing investments, lower the riskiness of their operations, and decrease asset liquidity. While managerial ownership is intended to align the interests of managers and shareholders, the presence of corruption appears to encourage undiversified managers to decrease risk-taking. Our evidence is consistent with agency theory and the asset-shielding argument that political corruption discourages managers from taking risks that expose firms to expropriation by politicians, resulting in suboptimal corporate policies.

CSR and idiosyncratic risk: Evidence from ESG information disclosure

Using the corporate social responsibility (CSR) report disclosure as an external shock on investors’ heterogeneous belief in China, we find that firms with environmental, social and governance (ESG) information disclosure have lower idiosyncratic risk than their counterparts. This finding is robust to the parallel-trend assumption, placebo test, PSM-DID design, and alternative idiosyncratic risk calculation. We conclude that CSR engagement could reduce firms’ idiosyncratic risk by providing additional nonfinancial information to reduce investors’ opinion divergence.

Fraternal twins—Should investors be careful?*

AbstractAfter analyzing portfolio differences between separate account‐mutual fund twins, we find that dissimilar “fraternal twins” show significantly lower joint performance than “identical twins.” This finding is consistent with fraternal twins competing for the limited attention of a manager while identical twins mutually profit. Furthermore, the effect is stronger for separate accounts, which is probably due to investors having the opportunity to influence managers’ investment decisions according to their preferences. These results are independent of differences in known investment constraints. However, the findings may be driven by separate account investors’ preferences for higher liquidity and lower idiosyncratic risk.

Industry centrality: Weak ties, industry attributes, and managerial contracting

AbstractCentrality in the network of interindustry trade relationships provides novel insights into an industry's economic attributes and managerial incentive contracts prevalent in the industry. More “central” industries trade with a large number of industries, implying numerous but relatively weaker interindustry ties. Weakness of interindustry ties suggests that relationship‐specific investment (RSI) will be less important and output will be relatively more commoditized in central industries. As predicted, central industry firms are less innovative, face greater competition, and have lower idiosyncratic risk. Further, CEOs in central industries receive lower pay and weaker incentives. Tournament incentives are also weaker in more central industries.

A financial restatement, media attention and stock idiosyncratic risk in the Chinese stock market

PurposeThis paper aims to enrich the scope of the influence of media reports on the stock risk, and it also provides a path to support the research on the relationship between media reports and idiosyncratic risks in the stock market.Design/methodology/approachThe authors select financial restatement samples of listed companies in China from Jan 2015 to Dec 2017 to explore the impact of the financial restatement on the idiosyncratic risk of stocks. Further, the financial restatement that has more media attention may play a more significant role in promoting the idiosyncratic risk.FindingsThe authors found that the financial restatement of listed companies has a significant positive effect on the idiosyncratic risk of stocks. Specifically, the idiosyncratic risk changed five months before the restatement. After the restatement, the idiosyncratic risk increased by 83.47 in five days then decreased slowly, which lasted about one year. The restatement caused by sensitive issues and legal issues has a greater impact on the idiosyncratic risk. Both current restatement and delayed restatements will increase the idiosyncratic risk of stocks, but the impact of the latter is higher than the former.Research limitations/implicationsPossible deficiencies in the paper are that the number of restatements caused by major accounting errors is low. Therefore, no regular conclusions were drawn on the impact of the financial restatement caused by major accounting errors.Practical implicationsThe conclusions provide a basis for targeted supervisory measures on the restatements of listed companies. The increase in financial restatements is closely related to the lack of governance mechanisms in the stock market. For investors, although the mystery of idiosyncratic volatility exists significantly in the market, the company's valuation level will affect the relationship between the idiosyncratic risk and expected return. Investors should pay attention to the intrinsic value of the company and should not blindly pursue stocks with a low idiosyncratic risk.Originality/valueThese conclusions may enrich the scope of the influence of media reports on the stock risk and also provide a path to support the research on the relationship between media reports and idiosyncratic risks in the capital market.

Does it pay to invest in environmental stocks?

This paper examines market-based returns and risks of environmental vis-à-vis non environmental stocks from a portfolio selection point of view. The selection of environmental stocks is a function of greenhouse gas emissions of firms in S&P 500 for the period from 2005 to 2018. Our findings show that stocks with superior environmental performance have lower idiosyncratic risk, but higher systematic risk, while we also control for endogeneity issues. We show that that it pays to invest in environmental stocks. Robustness analysis, such as counterfactual regressions and panel VAR, confirms our main findings, though it demonstrates some of underlying complexities.

Age, gender, and risk‐taking: Evidence from the S&P 1500 executives and market‐based measures of firm risk

AbstractThis paper contributes to the literature by examining whether the age and gender of the firm's top executives influence market‐based measures of firm risk. Using data on the S&P 1500 firms, we document that chief executive officer (CEO) and chief financial officer (CFO) age and gender have a direct effect on market‐based firm risk measures in addition to the indirect influence they may have through corporate policy choices. Specifically, we find that firms led by older CEOs and CFOs have less volatile stock returns and lower idiosyncratic risk. Although the relationship between executive gender and firm risk is more equivocal, our results suggest that female‐led firms are associated with lower levels of total and idiosyncratic risks after controlling for firm‐specific attributes, policy choices, and managerial risk‐taking incentives. We also document that CEO and CFO age and gender do not influence the level of systematic risk. Overall, our empirical findings demonstrate that the age and gender of the firm's top executives may have important implications for firm riskiness.

Information environment and stock price synchronicity: Evidence from auditor characteristics

The interpretation of stock price synchronicity in relation to price informativeness is controversial in the literature. We examine how firm‐specific variation relates to the quality of a firm's information environment by considering two auditor characteristics—audit firm size and audit firm tenure. Using a sample of U.S. listed firms from 2000 to 2018, we find that Big N audits and longer audit firm tenure are associated with higher stock price synchronicity and lower idiosyncratic risk. Our findings suggest that firm‐specific variation captures noise rather than firm‐specific news, supporting the emerging view that stock price synchronicity is a direct measure of price informativeness.

Brand equity and the Covid-19 stock market crash: Evidence from U.S. listed firms

Brand equity has played an important role in firms’ stock performance, especially during the stock market crash provoked by Covid-19. Our manuscript investigates how brand equity impacts stock performance during the Covid-19 crash. Firms with top brands should be a particularly attractive "safe harbor" in the crash to investors since consumer loyalty and demand advantages brought by brand equity enable firms to retain stable cash flows and mitigate the macroeconomic shock. Based on U.S. listed firms, we find that firms with top brands experience higher stock returns, lower systematic risk and lower idiosyncratic risk in the Covid-19 crash than other firms. Moreover, our findings are used to distinguish the brand equity effect from the corporate social responsibility (CSR) effect on stock performance during the Covid-19 crash.

Financial Reporting Quality, Corporate Governance, and Idiosyncratic Risk: Evidence from a Frontier Market

We extend current literature by providing empirical evidence on the impacts of financial reporting quality and corporate governance mechanism - two firm-level determinants that are strongly affected by the unique market setting and regulatory framework in emerging/frontier markets - and idiosyncratic risk in Vietnam. Utilizing different panel data analysis techniques, we find high-quality financial reports can mitigate firm-specific risk. Firms with high state ownership tend to have lower idiosyncratic risk too, implying the monitoring role of the government. We also document a positive link between board size and firm specific risk. Our results are thus beneficial for industry regulators and firms in ensuring good governance and reporting framework to better manage firm risk.

Risco idiossincrático e estrutura de propriedade: a possibilidade de diversificação explicada pela concentração de propriedade

A pesquisa tem como objetivo analisar a relação do risco idiossincrático e a concentração de propriedade. Foram utilizados os modelos de 3-Fatores de Fama e French (1993), dados em painel e regressão quantílica. A amostra de pesquisa englobou as empresas do IBrX-100, entre 2011 a 2015. Os resultados não comprovam a relação entre a concentração de propriedade e o risco idiossincrático pelo modelo de dados em painel, no entanto na regressão quantílica foi encontrada relação inversa entre o free float e o risco, indicando que empresas com maior percentual de ações em free float possuem menor risco idiossincrático. Além destes achados o tamanho e o pagamento de dividendos também apresentaram relação significativa com o risco. O estudo contribui para a área de pesquisa ao examinar a relação entre estrutura de propriedade e risco idiossincrático, visto que o conhecimento deste risco específico auxilia nas decisões de investimento relacionadas aos riscos.

Why is There a Secular Decline in Idiosyncratic Risk in the 2000s?

Except for relatively short but intense episodes of high market risk, average idiosyncratic risk (IR) falls steadily after 2000 until almost the end of our sample period in 2017. The decrease has been such that from 2012 to 2017 average IR was lower than any time since 1965. The secular decline can be explained by the fact that U.S. publicly listed firms have become larger, older, and their stock more liquid. The same changes that bring about historically low IR lead to increasingly high market-model R-squareds.