Financial Linkage via Idiosyncratic Shocks: A Case in an Emerging Market

Slow diffusion of information in inefficient markets can lead to the transmission of idiosyncratic shocks and make some financial linkages among firms. Using monthly data from 250 firms on Tehran Stock Exchange, we predict the links originated from the idiosyncratic shocks. We use the extracted links for two purposes. In the first step, we examine whether considering the idiosyncratic shocks can lead to a positive abnormal return. In addition, we investigated how the idiosyncratic shocks can help to solve the puzzle of idiosyncratic volatility in the Tehran Stock Exchange. The results show that a portfolio with more shocks yields a significant positive abnormal return. The results also show that using the average idiosyncratic shocks cannot help to solve the puzzle of idiosyncratic volatility. Since the first step results show the significant effect of slow information diffusion on asset returns, we can examine the idiosyncratic shocks as a risk propagation channel in the financial network. Using the network theory, we investigate the idiosyncratic shocks contagion in the financial market. We consider the centrality measures to identify the most vulnerable and systemically important firms and sectors in the financial system. The results show that the portfolios consisting of vulnerable firms can make an abnormal positive alpha with the expense of high systemic risk.