Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle

65 Pages Posted: 31 Mar 2014 Last revised: 29 Feb 2020

See all articles by Zhiyao Chen

Zhiyao Chen

The Chinese University of Hong Kong (CUHK) - Department of Finance

Ilya A. Strebulaev

Stanford University - Graduate School of Business; National Bureau of Economic Research

Yuhang Xing

Rice University

Xiaoyan Zhang

Tsinghua University - PBC School of Finance

Date Written: April 16, 2018

Abstract

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 returns and alphas in firms with high idiosyncratic volatility.

Keywords: risk-shifting, idiosyncratic volatility puzzle, profitability, agency conflict

JEL Classification: G12, G32

Suggested Citation

Chen, Zhiyao and Strebulaev, Ilya A. and Xing, Yuhang and Zhang, Xiaoyan, Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle (April 16, 2018). Rock Center for Corporate Governance at Stanford University Working Paper No. 182 , Available at SSRN: https://ssrn.com/abstract=2417965 or http://dx.doi.org/10.2139/ssrn.2417965

Zhiyao Chen (Contact Author)

The Chinese University of Hong Kong (CUHK) - Department of Finance ( email )

Shatin, N.T.
Hong Kong

Ilya A. Strebulaev

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

HOME PAGE: http://faculty-gsb.stanford.edu/strebulaev/

National Bureau of Economic Research ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Yuhang Xing

Rice University ( email )

6100 South Main Street
Houston, TX 7705-1892
United States

Xiaoyan Zhang

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

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