Journal of Banking and Finance
Volume 35, Issue 6, June 2011, pp1563-1580
 

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Dong Wook Lee
Korea University Business School
Mark H. Liu
University of Kentucky - Gatton College of Business and Economics
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=887026



Abstract

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 monotonically 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 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 Yu (2000)), and (2) the studies arguing that more information in price reduces idiosyncratic return volatility (e.g., West (1988) and Kelly (2005)).

Keywords

idiosyncratic volatility, noisy rational expectations equilibrium, price informativeness