Strategic Risk Shifting and the Idiosyncratic Volatility Puzzle

We find strong empirical support for the risk-shifting mechanism to account for the puzzling negative relation between idiosyncratic volatility and future stock returns documented by Ang, Hodrick, Xing, and Zhang (2006). First, equity holders take on high idiosyncratic risk investments when their firms receive negative cash flow shocks, have positive debt or have more long-term debt. Second, the strategically increased idiosyncratic volatility decreases the sensitivity of stocks to assets and results in low stock returns. Specifically, this strategic component alone explains 66.06 to 89.96% of the negative impact of total idiosyncratic volatility on future stock returns.