Two Essays on Ambiguity and Stock Return Volatility

This dissertation includes two essays on ambiguity and stock return volatility. The first essay focuses on the degree of ambiguity in the firm news, and studies the impact of ambiguous information regarding dividends and earnings on stock prices. Two proxies are constructed for firm-level ambiguity, measuring qualitative and uncertain aspects of news. The central finding is that stock prices react more strongly to bad news than good news. In addition to the asymmetric effect documented, the magnitude of this effect is larger as news becomes more ambiguous. Results are robust to alternative explanations. Taken together, these findings provide empirical evidence consistent with the theory of ambiguity aversion, and show that firm-specific ambiguity matters for financial decision making. The second essay, coauthored with Hwagyun Kim, studies the idiosyncratic volatility (IVOL) puzzle. Recent studies find stock returns are negatively related to IVOL. We find that aggregate variables known to explain stock market volatility affect the IVOL and portfolio returns sorted by IVOL. Macroeconomic volatilities, yield spreads, dividend yield, trading volume and common factors of earnings forecast dispersions are important drivers of IVOL. Macro factors produce the negative pattern, consistent with theories of intertemporal hedging demand. Teasing out the common IVOL part, the residual IVOL is positively and significantly related to stock returns and the idiosyncratic portions of earnings forecast dispersions. This is consistent with ambiguity aversion and incomplete market hypotheses