Does More Information in Stock Price Lead to Greater or Smaller Idiosyncratic Return Volatility?

61 Pages Posted: 25 Mar 2008 Last revised: 14 Nov 2010

See all articles by Dong Wook Lee

Dong Wook Lee

Korea University

Mark H. Liu

University of Kentucky - Gatton College of Business and Economics

Date Written: November 12, 2010

Abstract

We investigate the relation between price informativeness and idiosyncratic return volatility in a multi-asset, multi-period noisy rational expectations equilibrium. Idiosyncratic return volatility is decomposed into two parts: (1) the part caused by noise, and (2) the part caused by information regarding the firm's fundamental value. We show that the first component decreases with price informativeness, while the second component first decreases and then increases with price informativeness. Our main results are as follows. First, there exist no parameter values such that idiosyncratic return volatility increases monotonically with price informativeness. Second, there exist parameter values such that the relation between price informativeness and idiosyncratic return volatility is U-shaped. Finally, there exist parameter values such that idiosyncratic return volatility decreases monotonically with price informativeness. Using several price informativeness measures, we empirically document a U-shaped relation between price informativeness and idiosyncratic return volatility. Our study therefore reconciles the opposing views expressed in the following two strands of literature: (1) the growing body of research showing that firms with more informative stock prices have greater idiosyncratic return volatility (e.g., Morck, Yeung, and Yu (2000)), and (2) the studies arguing that more information in price reduces idiosyncratic return volatility (e.g., West (1988) and Kelly (2005)).

Keywords: idiosyncratic volatility, noisy rational expectations equilibrium, price informativeness

JEL Classification: G12, G14

Suggested Citation

Lee, Dong Wook and Liu, Mark H., Does More Information in Stock Price Lead to Greater or Smaller Idiosyncratic Return Volatility? (November 12, 2010). Journal of Banking and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=887026

Dong Wook Lee

Korea University ( email )

1 Anam-dong 5 ka
Seoul, 136-701
Korea, Republic of (South Korea)
+82.2.3290.2820 (Phone)
+82.2.3290.1307 (Fax)

Mark H. Liu (Contact Author)

University of Kentucky - Gatton College of Business and Economics ( email )

550 South Limestone
Lexington, KY 40506
United States
859-257-9842 (Phone)
859-257-9688 (Fax)

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