Learning About CEO Ability and Stock Return Volatility

Charles A. Dice Center Working Paper No. 2013-05

Fisher College of Business Working Paper No. 2013-03-05

59 Pages Posted: 4 Mar 2013 Last revised: 30 Jul 2014

See all articles by Yihui Pan

Yihui Pan

University of Utah - Department of Finance

Tracy Yue Wang

University of Minnesota - Twin Cities - Carlson School of Management

Michael S. Weisbach

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: July 28, 2014

Abstract

When there is uncertainty about a CEO’s quality, news about the firm causes rational investors to update their expectation of the firm’s value for two reasons: Updates occur because of the direct effect of the news, and also because news leads investors to update their assessment of the CEO’s quality, which changes expected future cash flows. As a CEO’s quality becomes known more precisely over time, the latter effect becomes smaller, decreasing the stock price reaction to news and lowering stock return volatility over the CEO’s tenure. We formally model this idea, and evaluate its implications using a large sample of CEO turnovers in U.S. public firms. Our estimates indicate that there is statistically significant and economically important market learning about CEO ability, even for CEOs whose appointments occur for exogenous reasons. Consistent with this model, stock return volatility and the absolute value of stock price reactions to news, decline with CEO tenure in a convex manner. The decline is faster when there is higher ex ante uncertainty about the CEO’s ability and more transparency about the firm’s prospects. Our estimates of the learning model suggest that uncertainty about CEO ability contributes substantially to return volatility, accounting for approximately 25% of total stock return volatility at the time of CEO turnover.

Keywords: CEO turnover, exogenous turnover, stock return volatility, idiosyncratic volatility, Bayesian learning, learning speed

JEL Classification: G32, G34, M12, M51

Suggested Citation

Pan, Yihui and Wang, Tracy Yue and Weisbach, Michael S., Learning About CEO Ability and Stock Return Volatility (July 28, 2014). Charles A. Dice Center Working Paper No. 2013-05; Fisher College of Business Working Paper No. 2013-03-05. Available at SSRN: https://ssrn.com/abstract=2228136 or http://dx.doi.org/10.2139/ssrn.2228136

Yihui Pan

University of Utah - Department of Finance ( email )

David Eccles School of Business
Salt Lake City, UT 84112
United States

Tracy Yue Wang

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

Michael S. Weisbach (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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