We find strong empirical support for the risk-shifting mechanism to account for the puzzling negative relation between idiosyncratic volatility and future stock returns. First, equity holders take on investments with high idiosyncratic risk when their firms are in distress and receive less monitoring from institutional holders as well as when the aggregate economy is in a bad state. Second, the strategically increased idiosyncratic volatility decreases equity betas, particularly in bad states when the market risk premium is high. The negative covariance between the equity beta and the market risk premium causes low and negative returns and alphas in firms with high idiosyncratic volatility.
Bibliographical noteThe authors acknowledge detailed and constructive comments from Tomasz Piskorski and two anonymous referees as well as suggestions and discussions from Yakov Amihud, Kerry Back, Ilan Cooper, Lorenzo Garlappi, Jarrad Harford, Avi Kamara, Gi Kim, Gang Li, Ravindra Sastry, Stephan Siegel, Neng Wang, Lance Young, and Fernando Zapatero as well as seminar participants at Australian National University, City University of Hong Kong, City University of New York (Queens), Erasmus University, Maastricht University, Manchester Business School, Purdue University, Tilburg University, University of Connecticut, University of Illinois at Urbana-Champaign, University of Massachusetts, University of New South Wales, University of Hong Kong, University of Technology Sydney, University of Washington, the 2015Annual Meetings of Western Finance Association (Seattle),the 2015 Annual Meetings of European Finance Association(Vienna), the 2014 North American Summer Meeting of the Econometric Society (Minnesota), the 2014 Jerusalem Finance Conference (Hebrew University), the 2014 Frontiers of Finance Conference (Warwick Business School), and the 2014China International Conference in Finance. They thank Yuxin Luo for excellent research assistance.
- Agency conflicts
- Idiosyncratic volatility puzzle
- Risk shifting