Fundamental and Information Uncertainties, Business Cycle, and Idiosyncratic Stock Volatility
Posted: 18 Apr 2015
Date Written: April 16, 2015
This paper examines empirically the effect of business cycle on fundamental and information uncertainties and whether this relationship accentuates or attenuates idiosyncratic stock volatility. Fundamental uncertainty refers to the uncertainty about firms’ future cash flows and earnings, while information uncertainty captures the uncertainty about the true economic performance of the firm due to financial reporting imprecision and inaccuracy. This paper argues that on the one hand a positive relation between firm-level fundamental uncertainty and economic recession is expected because of unpredictability of earnings and cash flows of the firm during recession. On the other hand, information uncertainty is expected to be lower during recession because regulators and investors focus more on downside risk and require conservative reporting by management. The empirical evidence is largely consistent with these predictions. The paper further documents that idiosyncratic stock volatility increases (reduces) with fundamental (information) uncertainty during both recession and expansion, but the effect is much more pronounced during economic recession than economic expansion.
Keywords: Business cycle; fundamental uncertainty; information uncertainty; idiosyncratic return volatility
JEL Classification: E32, D82, G32
Suggested Citation: Suggested Citation