R2 and Idiosyncratic Risk Are Not Interchangeable

Posted: 27 Jul 2014

See all articles by Bin Li

Bin Li

University of Houston - Department of Accountancy & Taxation

Shivaram Rajgopal

Columbia Business School

Mohan Venkatachalam

Duke University - Fuqua School of Business

Date Written: July 25, 2014

Abstract

A growing literature investigates the association between stock return variation and several aspects of information and governance structures, both in cross-country settings and cross-firm settings within the U.S. Several papers in this literature use idiosyncratic stock return volatility (σ_e^2) as the measure of firm-specific return variation whereas others use return synchronicity, or R2. Although these two variables are economically equivalent, researchers interpret them differently depending on their assumptions about whether lower R2 (or higher σ_e^2) captures firm-specific news or noise. We show that higher idiosyncratic volatility (or equivalently, lower R2) is associated with poorer information environments, measured as higher PIN scores, higher bid-ask spreads, greater price delay, greater levels of illiquidity, and more zero return days. In addition, we demonstrate, both analytically and empirically, that when the researcher is interested in assessing the association between R2 and some independent variable, he should control for (i) aggregate market return variation in cross-country settings; and (ii) firm-specific beta in cross-sectional settings.

Suggested Citation

Li, Bin and Rajgopal, Shivaram and Venkatachalam, Mohan, R2 and Idiosyncratic Risk Are Not Interchangeable (July 25, 2014). Accounting Review, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2472122

Bin Li

University of Houston - Department of Accountancy & Taxation ( email )

Bauer College of Business
4800 Calhoun Road
Houston, TX 77204
United States

Shivaram Rajgopal (Contact Author)

Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Mohan Venkatachalam

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7859 (Phone)
919-660-7971 (Fax)

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Abstract Views
1,926
PlumX Metrics