Economic Consequences of Idiosyncratic Information in Diversified Markets
36 Pages Posted: 21 Feb 2012
Date Written: January 10, 2012
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.
Keywords: Cost of capital, moral hazard, systematic and idiosyncratic risk
JEL Classification: G12, G14, G31, M41
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