Ineffective corporate governance: Director busyness and board committee memberships

Our paper examines whether holding multiple outside board seats compromises a director’s ability to effectively perform monitoring duties. Analyzing over 1400 firms, we report that individuals who hold more outside directorships serve on fewer board committees. The relation, however, appears non-linear, U-shaped, and in support for both the busyness and the reputation hypotheses. In addition, we find that holding more outside board seats decreases the likelihood of membership on compensation and audit committees. The findings substantiate evidence [Akhigbe, A., Martin, A.D., 2006. Valuation impact of Sarbanes–Oxley: Evidence from disclosure and governance within the financial services industry. Journal of Banking and Finance 30 (3), 989–1006] of value relevance of board committee structures. Additional analysis of committee memberships suggests that women and ethnic minorities are placed on more board committees. Also, directors on smaller and independent boards serve on more committees. Finally, it appears that the Sarbanes–Oxley act had a material impact on the association between the number of multiple board seats and committee memberships.     

Expected stock returns,common idiosyncratic volatility and average idiosyncratic correlation

Motivated by Herskovic et al. (2016), we examine the role of the average idiosyncratic correlation (ICOR) in two types of markets: an emerging market and a developed market. Examining daily stock data from the Chinese stock market for the period 1995 to 2020 and from the US for the period 1926 to 2019, we adopt high-dimensional principal component analysis (PCA) and thresholding methods to re-estimate ICOR. We find that ICOR plays an important role in explaining the expected stock returns, as the common idiosyncratic volatility (CIV) does in Herskovic et al. (2016). ICOR has been neglected in the literature due to large estimation error in the idiosyncratic covariance matrix and our analysis provides evidence that ICOR is nonnegligible in both markets when we control for several common market factors. We show that the average idiosyncratic covariance, which is the numerator of ICOR, exhibits the same pattern as CIV. Furthermore, our regression analyses of expected stock returns in response to ICOR change in both markets show that, in contrast to the negative result for CIV, the stocks’ high risk exposure to ICOR change comes with a higher risk premium, perhaps because of the synchronized but disproportionate changes in the monthly idiosyncratic covariance and idiosyncratic volatility.     

Incomplete information,idiosyncratic volatility and stock returns

When investors have incomplete information, expected returns, as measured by an econometrician, deviate from those predicted by standard asset pricing models by including a term that is the product of the stock’s idiosyncratic volatility and the investors’ aggregated forecast errors. If investors are biased this term generates a relation between idiosyncratic volatility and expected stocks returns. Relying on forecast revisions from IBES, we construct a new variable that proxies for this term and show that it explains a significant part of the empirical relation between idiosyncratic volatility and stock returns.     

Firm life cycle and idiosyncratic volatility

This paper investigates the association between idiosyncratic volatility and firm life cycle stages. Since firm performance and availability of information vary across life cycle stages, and such variation affects uncertainty about future cash flows and stock returns, we argue that idiosyncratic volatility also varies across firm life cycle stages. Using US data, this study shows that idiosyncratic volatility is significantly higher in the introduction and decline stages, and significantly lower in the growth and mature stages, when compared to that in the shake-out stage. Our study also reveals that the roles of both cash flow volatility and information uncertainty in affecting idiosyncratic volatility vary depending on firm life cycle stages. Our results are robust to alternative specifications of life cycle proxies and idiosyncratic volatility, and to an alternative regression specification.     

Liquidity costs,idiosyncratic volatility and expected stock returns

This paper considers liquidity as an explanation for the positive association between expected idiosyncratic volatility (IV) and expected stock returns. Liquidity costs may affect the stock returns, through bid-ask bounce and other microstructure-induced noise, which will affect the estimation of IV. We use a novel method (developed by Weaver, 1991) to eliminate microstructure influences from stock closing price-based returns and then estimate IV. We show that there is a premium for IV in value-weighted portfolios, but this premium is less strong after correcting returns for microstructure bias. We further show that this premium is driven by liquidity in the prior month after correcting returns for microstructure noise. The pricing results from equally-weighted portfolios indicate that IV does not predict returns either before or after controlling for liquidity costs. These findings are robust after controlling for common risk factors as well as analysing double-sorted portfolios based on IV and liquidity.     

Financial reporting quality and idiosyncratic return volatility

Campbell et al. (2001) document that firms’ stock returns have become more volatile in the U.S. since 1960. We hypothesize and find that deteriorating earnings quality is associated with higher idiosyncratic return volatility over 1962–2001. These results are robust to controlling for (i) inter-temporal changes in the disclosure of value-relevant information, sophistication of investors and the possibility that earnings quality can be informative about future cash flows; (ii) stock return performance, cash flow operating performance, cash flow variability, growth, leverage and firm size; and (iii) new listings, high-technology firms, firm-years with losses, mergers and acquisitions and financial distress.     

Aggregate idiosyncratic volatility,dynamic aspects of loss aversion,and narrow framing

We consider the economy in which an agent faces, in addition to market risk, an additive independent background risk in consumption. In contrast to the Lucas (Econometrica 46:1429–1445, 1978) complete consumption insurance model, under plausible assumptions about the unconditional mean and variance of the agent’s subjective distribution of background risk the model with the additive independent background risk fits the historical average excess return on the US stock market with the coefficient of relative risk aversion (RRA) below five for the subsets of households designated as assetholders. The greater the size and/or the lower the expected value of background risk, the lower (compared to the Lucas (Econometrica 46:1429–1445, 1978) model) the value of the RRA coefficient needed for the model with background risk to match the historical average equity premium. Allowing for an extremely unlike large decrease in the agent’s consumption considerably decreases the required coefficient of RRA. It is concluded that the presence of the additive independent background risk in the consumption of assetholders can account for nearly 60 % of the historical average equity premium, hence rationalizing the equity premium puzzle of Mehra and Prescott (J Monet Econ 15:145–162, 1985). With RRA below five, the model with background risk is consistent with the historical average real interest rate if the agent has the subjective time discount factor lower than, but close to, 1. The findings are robust to the assumed type of background risk, the proxy for the market portfolio, and the threshold value in the definition of assetholders.     

Cross section of option returns and idiosyncratic stock volatility

This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.     

The return impact of realized and expected idiosyncratic volatility

We show that the negative relation between realized idiosyncratic volatility, measured over the prior month, and returns is robust in non-January months. Controlling for realized idiosyncratic volatility, we show that the relation between returns and expected idiosyncratic volatility is positive and robust. Realized and expected idiosyncratic volatility are separate and important effects describing the cross-section of returns. We find the negative return on a zero-investment portfolio that is long high realized idiosyncratic volatility stocks and short low realized idiosyncratic volatility stocks is dependent on aggregate investor sentiment. In cross-sectional tests, we find the negative relation is weaker for stocks with a large analyst following and stronger for stocks with high dispersion of analyst forecasts. The positive relation between expected idiosyncratic volatility and returns is not due to mispricing.     

Financial distress and idiosyncratic volatility: An empirical investigation

We investigate the link between distress and idiosyncratic volatility. Specifically, we examine the twin puzzles of anomalously low returns for high idiosyncratic volatility stocks and high distress risk stocks, documented by Ang et al. (2006) and Campbell et al. (2008), respectively. We document that these puzzles are empirically connected, and can be explained by a simple, theoretical, single-beta CAPM model.     

Executive stock options: volatility,managerial decisions and agency costs

This paper proposes a new rationale for understanding managerial contracts which set-out to induce stock price volatility in the form of granting of executive stock options. First, we suggest that previous research focuses too much on short term volatility effects and offering neither a theoretical or empirical perspective on incentives which might influence long-term behaviour. To address this, we offer a theoretical structure of why managerial incentives might be important in determining the evolution of volatility over the life of an option contract and provide empirical support for our views. Second, we examine the impact of option moneyness on managerial behaviour over time and provide an analysis, with supporting empirical work, of the unintended incentives thereby created. Our approach suggests that volatility-inducing contracts do not work in the intended manner and supports a growing body of work which indicates that option-based remuneration does not incentivise managers to enhance corporate performance. Our evidence is within a UK context, based on a near-population sample size.     

Global investigation on the country-level idiosyncratic volatility and its determinants

Adapting the Fama–French three-factor model to a global context, this paper investigates idiosyncratic volatility as a measure of country-specific risk, and explores its determinants by using the equity and risk data of 47 developed and emerging countries during the period 1995–2016. We find the stock market turnover to have a positive and significant impact on the country-level idiosyncratic volatility, while information disclosure and investor uncertainty avoidance degree are negatively associated with country-level idiosyncratic risk. Moreover, improvements in economic, financial, and political risks, as measured by GDP growth, FX stability, foreign debt health, and non-corruption degree decrease the country-level idiosyncratic volatility significantly. Among all sets of market structure, investor preference, and economic, financial, and political risk variables considered, we find financial risk factors, FX stability and foreign debt health, to have the highest explanatory power over the cross-sectional differences in country-level idiosyncratic risk.     

Dynamic effects of idiosyncratic volatility and liquidity on corporate bond spreads

We study the dynamic impact of idiosyncratic volatility and bond liquidity on corporate bond spreads over time and empirically disentangle both effects. Using an extensive data set, we find that both idiosyncratic volatility and liquidity are critical mainly for the distress portfolios, i.e., low-rated and short-term bonds; for others only volatility matters. The effects of volatility and liquidity shocks on bond spreads were both exacerbated during the recent financial crisis. Liquidity shocks are quickly absorbed into bonds prices; however, volatility shocks are more persistent and have a long-term effect. Our results overall suggest significant differences between how volatility and liquidity dynamically impact bond spreads.     

Information,market power,and price volatility

We consider demand function competition with a finite number of agents and private information. We show that any degree of market power can arise in the unique equilibrium under an information structure that is arbitrarily close to complete information. Regardless of the number of agents and the correlation of payoff shocks, market power may be arbitrarily close to zero (the competitive outcome) or arbitrarily large (so there is no trade). By contrast, price volatility is always lower than the variance of the aggregate shock across all information structures. Alternative trading mechanisms lead to very distinct bounds as a comparison with Cournot competition establishes.     

Short-sale constraints and the idiosyncratic volatility puzzle: An event study approach

Using three natural experiments, we test the hypothesis that investor overconfidence produces overpricing of high idiosyncratic volatility stocks in the presence of binding short-sale constraints. We study three events: IPO lockup expirations, option introductions, and the 2008 short-sale ban on financial firms. Consistent with our prediction, we show that when short-sale constraints are relaxed, event stocks with high idiosyncratic volatility tend to experience greater price reductions, as well as larger increases in trading volume and short interest, than those with low idiosyncratic volatility. These results hold when we benchmark event stocks with non-event stocks with comparable idiosyncratic volatility. Overall, our findings suggest that biased investor beliefs and binding short-sale constraints contribute to idiosyncratic volatility overpricing.     

The role of investor attention in idiosyncratic volatility puzzle and new results

Review of Quantitative Finance and Accounting - We find that stocks with low investor attention show a more substantial return-idiosyncratic volatility puzzle than stocks with high investor...     

Toxic chemical releases and idiosyncratic return volatility: A prospect theory perspective

We investigated whether and how firms’ toxic chemical releases (TCRs) affect idiosyncratic return volatility (IRV) using a prospect theory lens. Utilising a large sample of US public listed firms over the period 2001–2018, we find a significant and positive association between TCRs and IRV, suggesting that firms releasing more toxic chemicals have higher IRV. Additional analyses show that a positive association between TCR and IRV is more evident among firms with (i) high revenue, (ii) lower financial constraints and (iii) fewer environmental violations. A further test also suggests that a positive association between TCRs and IRV is contingent on political leadership ideology and market states. Our results remain consistent with weighted TCRs, IRV based on the Fama–French three-factor model, fixed-effect two-stage least square estimator (FE-2SLS), and other robustness checks. These findings shed light on the role of equity markets as a driver for capital-intensive pollution abatement activities and enhanced compliance with environmental laws, standards and best practices.     

Audit committee,board of director characteristics,and earnings management

This study examines whether audit committee and board characteristics are related to earnings management by the firm. A negative relation is found between audit committee independence and abnormal accruals. A negative relation is also found between board independence and abnormal accruals. Reductions in board or audit committee independence are accompanied by large increases in abnormal accruals. The most pronounced effects occur when either the board or the audit committee is comprised of a minority of outside directors. These results suggest that boards structured to be more independent of the CEO are more effective in monitoring the corporate financial accounting process.     

Stochastic volatility,power laws and long memory

Benoit B Mandelbrot comments on the paper by Blake LeBaron, on page 621 of this issue, by tracing the merits and pitfalls of power-law scaling models from antiquity to the present.