Economic Consequences of Idiosyncratic Information in Diversified Markets

36 Pages Posted: 21 Feb 2012

See all articles by Pingyang Gao

Pingyang Gao

Booth School of Business, University of Chicago

Robert E. Verrecchia

University of Pennsylvania - Accounting Department

Date Written: January 10, 2012

Abstract

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

Suggested Citation

Gao, Pingyang and Verrecchia, Robert E., Economic Consequences of Idiosyncratic Information in Diversified Markets (January 10, 2012). Chicago Booth Research Paper No. 12-09. Available at SSRN: https://ssrn.com/abstract=2008364 or http://dx.doi.org/10.2139/ssrn.2008364

Pingyang Gao (Contact Author)

Booth School of Business, University of Chicago ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Robert E. Verrecchia

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-6976 (Phone)
215-573-2054 (Fax)

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