The Information Content of Idiosyncratic Volatility

Abstract:     
This paper uses adverse selection in corporate information disclosure to explain a recently documented asset pricing anomaly. Ang, Hodrick, Xing, and Zhang (2006a) show that stocks with high idiosyncratic return volatilities tend to have low future returns. In this paper, we find that idiosyncratic volatility is also inversely related to future earning shocks. More importantly, we show that the return predictive power of idiosyncratic volatility is induced by its information content on future earnings. We provide empirical results to support our explanation that firms with poor prospect of future earnings tend to disclose less information, resulting in a higher degree of heterogeneity in investors beliefs, which in turn leads to higher stock return volatility and trading volume. Further analysis suggests that investors tend to underreact to earnings information in idiosyncratic volatility, and the mispricing of idiosyncratic volatility is inversely related to both investor sophistication and stock liquidity.

Number of Pages in PDF File: 28

Keywords: Idiosyncratic Volatility, Corporate Disclosure

JEL Classification: G12, G14

Accepted Paper Series