Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle

We find strong empirical support for the risk-shifting mechanism to account for the puzzling negative relation between idiosyncratic volatility and future stock returns documented by Ang, Hodrick, Xing, and Zhang (2006). First, underperformed firms have more incentives to take on high idiosyncratic risk investments. Using three different measures of idiosyncratic volatility, we show that firms increase their idiosyncratic risk in response to negative return on assets (RoAs) at least twice as much as they do in response to positive RoAs. Second, the increased idiosyncratic volatility reduces the sensitivity of stocks to assets and results in low future stock returns. Only the strategic risk-shifting component of idiosyncratic volatility predicted from the past RoAs has a significantly negative impact on future stock returns. Specifically, the strategic component alone explains 77.21% of the negative impact of monthly idiosyncratic volatility on monthly stock returns, which dominates other alternative explanations.

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