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

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 monoton-ically 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 commonly used 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 Y