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Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle: An Empirical Investigation

Author

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  • Zhiyao Chen

    (Chinese University of Hong Kong Business School, Chinese University of Hong Kong, Hong Kong)

  • Ilya A. Strebulaev

    (Graduate School of Business, Stanford University, Stanford, California 94305)

  • Yuhang Xing

    (National Bureau of Economic Research, Cambridge, Massachusetts 02138; Jones Graduate School of Business, Rice University, Houston, Texas 77005)

  • Xiaoyan Zhang

    (PBC School of Finance, Tsinghua University, Beijing 100083, P.R. China)

Abstract

We find strong empirical support for the risk-shifting mechanism to account for the puzzling negative relation between idiosyncratic volatility and future stock returns. First, equity holders take on investments with high idiosyncratic risk when their firms are in distress and receive less monitoring from institutional holders as well as when the aggregate economy is in a bad state. Second, the strategically increased idiosyncratic volatility decreases equity betas, particularly in bad states when the market risk premium is high. The negative covariance between the equity beta and the market risk premium causes low and negative returns and alphas in firms with high idiosyncratic volatility.

Suggested Citation

  • Zhiyao Chen & Ilya A. Strebulaev & Yuhang Xing & Xiaoyan Zhang, 2021. "Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle: An Empirical Investigation," Management Science, INFORMS, vol. 67(5), pages 2751-2772, May.
    • Handle: RePEc:inm:ormnsc:v:67:y:2021:i:5:p:2751-2772
    DOI: 10.1287/mnsc.2020.3593
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