Can Growth Options Explain the Trend in Idiosyncratic Risk?

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. Campbell, Lettau, Malkiel, and Xu (2001) document increasing firm-level return volatility but stable market and industry return volatilities over the last four decades. Subsequently, there has been a flurry of work attempting to characterize the upward trend in idiosyncratic volatility. 1 We now know that increasing idiosyncratic volatility is: (1) related to the level and variance of profitability (Pastor and Veronesi 2003 and Wei and Zhang 2006); (2) positively related to institutional ownership and expected earnings growth (Malkiel and Xu 2003); (3) negatively related to firm age We are grateful to Choong

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