Idiosyncratic risk(firm-specific risk) ; the risk that is unique to a specific firm
Under the CAPM theory, only systematic risk is priced and idiosyncratic risk is not, as it builds on the portfolio theory.
However, investors in reality may not hold perfectly diversfied portfolio. (2004 Goezmann and Kumar, 2001Campbell, Lettau, Malkiel, and Xu)
Ang, Hodrick, Xing, and Zhang (2006)
In the cross-section of stocks, high idiosyncratic valatility in one month predicts abysmal low average returns in the next month.
Prior research has not reached a theoretical or empirical consensus on whether earnings that are smoother than cash flows provide or, rather, garble information.
Provide information
- Arya, Glover, and Sunder (2003)
- Chaney and Lewis(1995)
- Sankar and Subramanyam(2001)
- Demski(1998)
Garble Information
- Leuz, Nanda, and Wysocki(2003)
- Lang, Raedy, and Yetman(2003)
- Barth, Lansman, and Lang(2006)
There are no consensus in the literature regarding whether earnings that are more volatile than cash flows either provide or garble information.
Earnings that are more volatile than cash flows reveal private information.
- Kirschenheiter and Melumad(2002)
- Basu(1997)
- Givoly and Hayn(2000)
- Ball and Shivakumar(2006)
More volatile earnings do not reveal private information, but rather reflect opportunistic behavior.
- Turner(2001)
- Riedl(2004)
H1a. There is an inverted-U-shaped relation between earnings that are smoother or more volatile than cash flows and informed trading.
--> if earnings that are smoother or more volatile than cash flows provide information, they will be associated with less informed trading, because private information is publictly available.
H1b. There is an U-shaped relation between earnings that are smoother or more volatile than cash flows and informed trading.
--> if eanings that are smoother or more volatile than cash flows garble information, they will be associated with more informed trading.
ACEV(Accrual component of Earnings Volatility)
E = CF+AC
Var(E) = Var(CF)+Var(AC)+2Cov(CF,AC)
ACEV = Var(AC)+2Cov(CF,AC) = Var(E)-Var(CF)
ACEV<0, smooth regime (earnings are smoother than cash flows)
ACEV=0
ACEV>0, volatile regime ( earnings are more volatile than cash flows)
Proxies for informed Trading
1. Bid-Ask Spread
the relation between the extent of informed trading and bid-ask spreads was first discussed in Bagehot(1971) and subsequently modeled by Copeland and Galai(1983), and Glosten and Milgrom(1985)
- A high level of informed trading leads to higher bid-ask spread
--> annual relative bid-ask spread using daily closing bids and asks in CRSP
Probability of informed trading (PIN)
according to Easley and O’Hara(1992), Easley et al.(1996). and Easley, Kiefer, and O’Hara(1997), the underlying parameters – the arrival rates of informed and uninformed traders and the probability of an infomation event – determine the likelihood that the market maker transacts with an infomed investor
- The higher the ratio of informed to uninformed investors, the higher the PIN
PIN ≒ informed/uninformed
