Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle
67 Pages Posted: 31 Mar 2014 Last revised: 26 Apr 2018
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 high-idiosyncratic-risk investments when their firms are in distress, as well as when the aggregate economy is in a bad state. Second, the strategically increased idiosyncratic volatility decreases the sensitivity of stocks to assets, particularly among distressed firms and in bad states when the market risk premium is high. The negative covariance between the stock-asset sensitivity and the market risk premium causes low stock returns.
Keywords: risk-shifting, idiosyncratic volatility puzzle, profitability, agency conflict
JEL Classification: G12, G32
Suggested Citation: Suggested Citation