Economic Consequences of Idiosyncratic Information in Diversified Markets
University of Chicago - Booth School of Business
Robert E. Verrecchia
University of Pennsylvania - Accounting Department
January 10, 2012
Chicago Booth Research Paper No. 12-09
While most accounting information is idiosyncratic in nature, economy-wide factors such as accounting standards affect the quality of idiosyncratic accounting information of many firms simultaneously. We study idiosyncratic and systematic features of accounting information by embedding a parsimonious, moral hazard problem into the framework of a multi-firm economy. Our model yields the insight that moral hazard distorts the sharing of idiosyncratic risk but does not affect the sharing of systematic risk. We extend this insight to achieve two results. First, the reduction in the risk premium for idiosyncratic risk is not captured by the risk premium of traded shares. Second, an economy-wide improvement in idiosyncratic information quality reduces the risk premium for idiosyncratic risk but increases the risk premium for systematic risk. Thus, its overall effect on the total risk premium is ambiguous and depends on firms’ risk profiles.
Number of Pages in PDF File: 36
Keywords: Cost of capital, moral hazard, systematic and idiosyncratic risk
JEL Classification: G12, G14, G31, M41working papers series
Date posted: February 21, 2012
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