Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle
64 Pages Posted: 31 Mar 2014 Last revised: 3 Sep 2019
Date Written: April 16, 2018
We find strong empirical support for the risk-shifting mechanism to account for the puzzling negative relation between idiosyncratic volatility and future stock returns. First, equity holders take on investments with high idiosyncratic risk when their firms are in distress and receive less monitoring from institutional holders, as well as when the aggregate economy is in a bad state. Second, the strategically increased idiosyncratic volatility decreases equity betas, particularly in bad states when the market risk premium is high. The negative covariance between the equity beta and the market risk premium causes low and negative returns and alphas in firms with high idiosyncratic volatility.
Keywords: risk-shifting, idiosyncratic volatility puzzle, profitability, agency conflict
JEL Classification: G12, G32
Suggested Citation: Suggested Citation