Stochastic Idiosyncratic Operating Risk and Real Options: Implications for Stock Returns

Idiosyncratic volatility generates a lot of interest in literature, as there are conflicting evidences regarding the relationship between stocks’ idiosyncratic volatility and future returns. In this paper, we re-investigate this relationship. We argue that the impact of idiosyncratic volatility on stock return is contextual, i.e., depending on the stocks’ attributes. We focus on stocks’ quality measures. We hypothesize that for companies with high quality measures, the idiosyncratic volatility would have a positive impact on stock return, as it is more likely to be idiosyncratic volatilities on the good side, while on the other hand, for companies with bad qualities, higher idiosyncratic volatility might lead to negative return, as these companies are facing larger default probabilities due to their higher idiosyncratic volatilities. Our empirical results show that within our expectations, for stocks with higher quality measures there is a positive and significant relationship between stocks’ future return and their idiosyncratic volatility, while the story for stocks with lower quality measures is mixed. Our research will contribute to the idiosyncratic volatility literature by providing a thorough and conditional analysis about its impact on stock returns. It will also provide insights for the investors who wish to better understand the impact of idiosyncratic volatility on future stock return and, thus, are able to make better investment decisions.

Starting in the 1990s, US bank assets grew more concentrated among a few large institutions. We explore the changing role of idiosyncratic volatility as a shaping force of the bank asset power law distribution. Our results reveal that idiosyncratic asset volatilities for bank-holding companies declined since the 1990s. To the extent that firm-specific shocks can have significant macroeconomic consequences, this result implies that even as one obvious source of aggregate risk and contagion--bank asset concentration--has increased, another important source--idiosyncratic volatility--has diminished.

Is There a Volatility Puzzle in the Hong Kong Stock Market?

For a typical firm, idiosyncratic volatility is as sensitive to the relative value of assets in place as to growth options. However, for firms dominated by assets in place (growth options), idiosyncratic volatility is more sensitive to the relative value of assets in place (growth options). Binding irreversibility constraint (uncertainty) makes the effect of assets in place (growth options) more pronounced. The institutional ownership in China’s (the U.S.) stock market is positively (negatively) related to idiosyncratic volatility. Our dynamic tests show two-way Granger-causality between institutional ownership and idiosyncratic volatility in the U.S. and one-way Granger-causality in China. It indicates that institutional investors behave differently in the U.S. and China. Stock characteristics are important factors which affect idiosyncratic volatility associated with institutional holding. Our findings are robust to controlling for the financial crisis period, proportions of institutional ownership, long-term and short-term institutional ownership, and different types of institutional investors. Using Sims' two-sided regression approach, we show that 1) there is bidirectional causality between institutional ownership and stock return volatility and 2) not accounting for the feedback effects from institutional ownership to return volatility yields the opposite institutional preferences on volatility. Subsequent analyses reveal that (surprisingly) prudence plays a role in institutions' preference on return volatility. But we fail to find support for the informational advantage argument in the literature. Lastly, we find weak evidence in the importance of growth opportunities in institutions' preferences on volatility.

Campbell et al.’s [2001] influential paper on idiosyncratic volatility has received a lot of research attention in recent years. The critical question for portfolio managers is: “How does idiosyncratic volatility...

Growth Options and Firm Valuation

The Mathematics of Idiosyncratic Volatility and the Small Firm Effect: Australian Evidence

High Idiosyncratic Volatility and Low Returns: A Prospect Theory Based Explanation

High Short Interest Effect and Aggregate Volatility Risk

This paper examines the idiosyncratic volatility puzzle and whether investor sentiment influences the relation between idiosyncratic volatility and stock returns in the Chinese stock market. The findings indicate the existence of a negative idiosyncratic volatility effect. In addition, the results show that the relation between idiosyncratic volatility and returns significantly depends on investor sentiment. Thus, investor sentiment plays a very important role in reconciling the relation between idiosyncratic volatility and stock returns in the Chinese stock market. This implies that investor sentiment may be one of the major risk factors that should be considered in the Chinese stock market. In terms of predictive ability of investor sentiment, idiosyncratic volatility and market volatility, the findings indicate that idiosyncratic volatility positively predicts future excess market returns in the Chinese stock market.

We examine the cross-sectional relation between idiosyncratic volatility and stock returns and propose that the joint effect of the percentage of zero returns, that affects the loading on the systematic risk factors, and the bid-ask spread, that inflates the variance of the returns, biases the estimate of idiosyncratic volatility and the resulting pricing ability of idiosyncratic volatility. We model the microstructure influence on returns and derive a closed-form solution for the bias in the estimated idiosyncratic volatility. Motivated by this theory, our empirical results show that controlling for the liquidity costs on the estimation of idiosyncratic volatility diminishes to insignificance the ability of idiosyncratic volatility estimates to predict future returns. We confirm our findings by examining external shocks to liquidity, due to reductions in the stated quotes after 1997 and the decimalization of quotes in 2001, and find a significant reduction in the pricing ability of idiosyncratic volatility. Finally, minimizing liquidity’s influence on the estimated idiosyncratic volatility, by orthogonalizing the percentage of zero return and spread effects on the estimated idiosyncratic volatility, demonstrates that the resulting idiosyncratic volatility estimate has little pricing ability.

Ambiguity, Macro Factors, and Stock Return Volatility

PurposeThis paper aims to investigate whether idiosyncratic volatility is a priced risk factor in the Australian stock market.Design/methodology/approachThe authors use the change in idiosyncratic volatility around acquisition announcements and the related stock price revaluation to test whether the idiosyncratic risk is priced. If the idiosyncratic risk is priced, increases (decreases) in idiosyncratic volatility should be associated with decreases (increases) in the acquirer’s stock price, as the latter’s future cash flows are discounted at a higher (lower) rate. The sample consists of 2,656 completed acquisitions by Australian listed firms over the period January 1990 to October 2014 for which deal value represents more than 5 per cent of the acquirer’s market value.FindingsIncreases (decreases) in idiosyncratic risk are associated with significant decreases (increases) in firm value. This negative relationship is robust to the presence of outliers; is unaffected by the incidence of the 2007-2008 financial crisis; holds using alternative measures of idiosyncratic risk; and is more significant after excluding the resources sector. Firms with a higher idiosyncratic risk prior to the acquisition, and firms avoiding stock to pay for the acquisition, experience a more significant stock price increase in relation to a decrease in idiosyncratic risk.Research limitations/implicationsConsidering the small size of the Australian economy, investors may have less scope to mitigate idiosyncratic risk. As a consequence, idiosyncratic risk is associated with the positive excess return, contrary to what standard asset pricing theory assumes. The results support Merton’s (1987) hypothesis that investors are exposed to idiosyncratic risk due to imperfect portfolio diversification and receive compensation for bearing that risk.Practical implicationsThe pricing of idiosyncratic risk may also explain why the Australian stock market has historically offered a high equity risk premium. A practical implication would be for international investors to take advantage of the diversification constraints of local investors to capture higher risk premiums and achieve superior returns.Originality/valueWhile prior studies demonstrate that stocks with higher idiosyncratic risk are associated with higher subsequent returns, the authors show that an increase in idiosyncratic risk is associated with a decrease in stock prices using acquisition announcements as shocks to a firm’s idiosyncratic risk. In other words, the results arise from within-firm variations rather than from cross-sectional differences in stock returns.

A closer look at the relationship between firm-specific return variation and stock returns

This paper investigates the empirical relationship between idiosyncratic volatility and the cross-section of stock returns of NEEQ Select. It finds that idiosyncratic volatility is positively related to expected stock returns, with no presence of idiosyncratic volatility anomalies. Idiosyncratic volatility serves as an important asset pricing factor of NEEQ Select, which better represents investors’ psychological expectation of idiosyncratic risk premium. Both expected and unexpected idiosyncratic volatility display a positive and robust relationship to stock returns, but unexpected idiosyncratic risk, which controls for unexpected returns, may exert relatively greater marginal effects. Based on the above conclusions, some suggestions are put forward to actively achieve the diversification management efficiency of NEEQ Select portfolios.