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RFS Advance Access originally published online on October 25, 2006
Review of Financial Studies 2008 21(6):2599-2633; doi:10.1093/rfs/hhl039
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org.

Can Growth Options Explain the Trend in Idiosyncratic Risk?

Charles Cao
Pennsylvania State University and the China Center for Financial Research

Timothy Simin
Pennsylvania State University

Jing Zhao*
Pennsylvania State University

Address correspondence to Timothy Simin, Department of Finance, Pennsylvania State University, 345 Business Building, University Park, PA 16802. E-mail: tsimin{at}psu.edu


  Abstract

While recent studies document increasing idiosyncratic volatility over the past four decades, an explanation for this trend remains elusive. We establish a theoretical link between growth options available to managers and the idiosyncratic risk of equity. Empirically both the level and variance of corporate growth options are significantly related to idiosyncratic volatility. Accounting for growth options eliminates or reverses the trend in aggregate firm-specific risk. These results are robust for different measures of idiosyncratic volatility, different growth option proxies, across exchanges, and through time. Finally, our results suggest that growth options explain the trend in idiosyncratic volatility beyond alternative explanations.

* current address: Jing Zhao, Assistant Professor of Finance, North Carolina State University, College of Management, 2801 Founders Drive, 2300 Nelson Hall, Raleigh NC 27695-7229

We are grateful to Choong Tze Chua, Keith Crocker, Craig Dunbar, Dong Hong, Eric Jacquier, Patrick Kelly, Bill Kracaw, Roger Loh, Michael Long, James Miles, Chris Muscarella, Dennis Sheehan, Chris Ting, Jun Tu, Mitch Warachka, Joe Zhang, and the seminar participants at the 2006 FMA conference, Pennsylvania State University, the University of Texas at Dallas, the University of Western Ontario, HEC Montreal, the University of Amsterdam, the Norwegian School of Management, and the University of Copenhagen for their helpful comments and suggestions. We also thank the Third NTU International Conference on Economics, Finance, and Accounting (IEFA) for financial support through their 2005 best paper award. Special thanks to Matt Spiegel and an anonymous referee for insights that greatly improved the quality of our paper.


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