Uncertain firm profits and (indirectly) priced idiosyncratic volatility

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