Uncertain Firm Profits and (Indirectly) Priced Idiosyncratic Volatility

61 Pages Posted: 5 Feb 2023

See all articles by Bharat Raj Parajuli

Bharat Raj Parajuli

Monash University

Xuhui (Nick) Pan

University of Oklahoma

Petra Sinagl

University of Iowa - Department of Finance

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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 returns 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, Bayesian updating, incomplete information, uncertainty, firm profitability.

Suggested Citation

Parajuli, Bharat Raj and Pan, Xuhui (Nick) and Sinagl, Petra, Uncertain Firm Profits and (Indirectly) Priced Idiosyncratic Volatility. Available at SSRN: https://ssrn.com/abstract=4349057 or http://dx.doi.org/10.2139/ssrn.4349057

Bharat Raj Parajuli (Contact Author)

Monash University ( email )

900 Dandenong Road
Caulfield East, VIC, 3145
Australia

Xuhui (Nick) Pan

University of Oklahoma ( email )

307 W Brooks
Norman, OK 73019
United States

Petra Sinagl

University of Iowa - Department of Finance ( email )

Iowa City, IA 52242-1000
United States

HOME PAGE: http://andrlikova.com

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