Uncertain firm profits and (indirectly) priced idiosyncratic volatility

60 Pages Posted: 7 May 2020 Last revised: 3 Jul 2022

See all articles by Xuhui (Nick) Pan

Xuhui (Nick) Pan

University of Oklahoma

Bharat Raj Parajuli

Monash University

Petra Sinagl

University of Iowa - Department of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: June 6, 2022

Abstract

We show that the negative relation between idiosyncratic volatility (IVOL) and expected returns exists only among firms with low profitability and high uncertainty about profitability. We propose an incomplete information model in which agents cannot disentangle systematic from idiosyncratic shocks. While not priced directly, IVOL affects expected re- turns by lowering signal accuracy, which decreases the factor loading on the priced systematic risk and yields the negative IVOL-return relation. The model predicts that this negative relation is the strongest among underperforming firms with highly uncertain profitability. When applied to U.S. equity data, we explain 86% of the negative IVOL-return relation.

Keywords: Idiosyncratic volatility puzzle, Bayesian updating, asymmetric signal precision, firm underperformance

JEL Classification: G12, G14

Suggested Citation

Pan, Xuhui (Nick) and Parajuli, Bharat Raj and Sinagl, Petra, Uncertain firm profits and (indirectly) priced idiosyncratic volatility (June 6, 2022). Available at SSRN: https://ssrn.com/abstract=3574790 or http://dx.doi.org/10.2139/ssrn.3574790

Xuhui (Nick) Pan

University of Oklahoma ( email )

307 W Brooks
Norman, OK 73019
United States

Bharat Raj Parajuli

Monash University ( email )

900 Dandenong Road
Caulfield East, VIC, 3145
Australia

Petra Sinagl (Contact Author)

University of Iowa - Department of Finance ( email )

Iowa City, IA 52242-1000
United States

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