Information Efficiency and Firm-Specific Return Variation

Abstract:     
This paper examines how a stock's information environment affects its idiosyncratic volatility and market model R-square. West (1988) argues that rapid information incorporation reduces idiosyncratic volatility, thereby raising R-square, while Morck, Yeung, and Yu (2000) contend the opposite, and suggest that R-square is a measure of information efficiency inversely related to the rate of information incorporation. Consistent with West (1988), I find that low R-square stocks are smaller and younger with lower institutional ownership, analyst coverage, and liquidity than their high R-square counterparts. Low R-square stocks have greater transactions costs, more tightly binding short sale constraints, fewer informed trades, and the greatest degree of information asymmetry and sensitivity to past market returns. A low market model R-square is thus indicative of a poor information environment with greater impediments to informed trade. R-square is not a robust measure of information efficiency. In contrast, the breadth of institutional ownership is positively associated with the quality of the information environment in a manner consistent with a measure of information efficiency.

Number of Pages in PDF File: 57

Keywords: Market efficiency, idiosyncratic volatility, information efficiency

JEL Classification: G12, G14

working papers series