On the information content of idiosyncratic equity return variation

Research in this thesis deals with some unexplored, or only partially explored, issues relating to the information content of volatility of the idiosyncratic component of asset returns at the firm and industry-level, both in the context of developed and emerging stock markets. Specific issues we have investigated include potential role of idiosyncratic volatility of equity returns for the explanation of future stock market volatility, aggregate economic activity, cross-border information transmission, and fundamental efficiency of stock prices. Chapter 2 of the thesis presents research into the information content of firm and industry-level idiosyncratic volatility, estimated as cross-sectional volatility (CSV), for future market-level volatility in Australia. We find that CSV does contain information beyond what is already contained in the lagged market-level return shocks and has a significant positive relationship with conditional market volatility. Our analysis gives new empirical evidence that the effect of CSV is stronger in relatively stable market conditions than in more volatile market conditions. We also examine how the information content of stock turnover and aggregate company announcements compares with that of CSV, and take a novel data-driven approach to verify whether CSV captures any information about multiple common factor shocks in asset returns. The explanatory power of CSV for future market volatility remains robust even after controlling for the effects of stock turnover, company announcements and omitted factor shocks in returns. These results are in line with the theoretical models relating volatility to the flow of information to the market, and suggest that the amount of information as captured by the firm and industry-level CSV shares a common co-movement with the market-wide information flow. In Chapter 3, unlike most other studies investigating the role of macroeconomic aggregates in explaining the fluctuations in stock market returns, we consider the possibility of reverse causality, and that using idiosyncratic volatility of industry-level stock returns in the context of Australia. Both the theories of investment and consumption under uncertainty and the models of sectoral reallocation provide rationale for the analysis. By explicitly modeling the cyclical patterns of industry-level volatility and relating it to corresponding cyclical behaviour of macroeconomic variables, we show that industry-level volatility is a leading indicator of the cyclical movements in output growth and inflation in Australia. We find complementary evidence from the multi-step Granger causality test and the impulse response analysis based on a vector autoregression of industry-level volatility, GDP growth, inflation and changes in unemployment rate. However, the forecast error variance decompositions suggest that although the industry-level volatility accounts for a significant fraction of the forecast error of inflation, this explains only a small fraction of output and unemployment uncertainties. Further analysis indicates that industry-level volatility contains better information about the future state of the economy than does aggregate stock market volatility. In Chapter 4, we explore a new but potentially important channel of crossborder information transmission between international stock markets ���� idiosyncratic volatility of stock returns. Specifically, we analyze the role of US and Japanese idiosyncratic volatility in transmitting information across three smaller but advanced Asia-Pacific stock markets – Australia, Hong Kong and Singapore. We find that, similar to cross-market first and second moment return correlations, market-wide measures of IV are also highly correlated across countries. The effect of US and Japanese IV information is found to be much stronger on cross-market conditional volatility process than on the returns process. Further, we find significant contemporaneous and dynamic information transmission from IV of the US and Japan to the trading volume of other stock markets. Transmission of IV information, in general, seems to have gained momentum in the period since the Asian crisis of 1997. Overall evidence presented in this chapter is consistent with the interpretation that IV may contain information about some unobservable factors driving international stock market co-movement. In Chapter 5, we make the first attempt to understand the direct relationship between firm-specific variations in returns and firm fundamentals by analyzing firmlevel micro panel data in the context of each of a set of emerging Asian stock markets. After properly accounting for unobserved firm-specific effects, volatility persistence and potential endogeneity bias, we find that firm-specific variation of stock returns is highly correlated with, and is significantly explained by, alternative proxies of firm-specific variation of fundamentals in a majority of the emerging markets in Asia. Further analysis reveals that the observed effect of firm-specific fundamentals variation on returns variation is not indirectly driven by some other factors known to affect stock return volatility, viz., firm size, stock turnover, and leverage. Consistent with the rational approach, these results suggest that stock prices in majority of the Asian emerging markets are not devoid of fundamentals