Corporate Hedging and the High Idiosyncratic Volatility Low Return Puzzle

Abstract

The literature offers various explanations to either support or refute the Ang et al. () high idiosyncratic volatility low return puzzle. Fu () finds a significantly positive contemporaneous relation between return and exponential generalized autoregressive conditional heteroskedastic idiosyncratic volatility. We use corporate hedging to shed light on this puzzle. Conceptually, idiosyncratic volatility matters to investors who face limits to diversification. But limits to diversification become less relevant for firms that consistently hedge. We confirm the main finding in Fu (), but only for firms that do not consistently hedge. For firms that adopt a consistent hedging policy, idiosyncratic volatility, whether contemporaneous or lagged, is insignificant in Fama–MacBeth regressions, controlling for size, book‐to‐market, momentum, liquidity, and industry effects.

Do Derivative Instruments Increase Firm Risk for Indonesia Non-Financial Companies?

“…This condition resulted in a lack of effectiveness of the derivatives used by the company. It is in line with the findings of Huang, Kabir, and Zhang (2017) that the use of derivatives by companies in developed countries can reduce the standard deviation of stock returns and systematic risk. Still, such conditions do not occur in developing countries.…”

“…According to Chng et al (2017), the concept of high returns and idiosyncratic volatility is real for companies that do not implement hedging strategies or implement inconsistent hedging strategies. However, when a company has derivative transactions/instruments with the objective of hedging consistently, then the level of firm risk can be suppressed so that idiosyncratic volatility is not an issue.…”

“…Meanwhile, the three-factor model theory assumes that idiosyncratic volatility can be diversified because investors hold a proportion of the market portfolio that can be well-diversified (Liu, Di lorio, & De Silva, 2014). Furthermore, Chng, Fang, Xiang, and Zhang (2017) states that company-specific risks can be diversified but are not relevant to the expected return. In CAPM, it only explains the problem of systematic risk, while the specific risk of the company cannot be explained through cross-sectional stock returns.…”

“…and Bradbury (2015) stated that net income volatility as accounting information uncertainty as well as leads to firm risk. Chng et al (2017) concluded that companies that have derivatives with hedging purposes are not relevant to diversify portfolios if the purpose is only to reduce idiosyncratic volatility instability. It is related to the decrease in information asymmetry between agents and principals.…”

“…It is related to the decrease in information asymmetry between agents and principals. Also, Chng et al (2017) stated that portfolio diversification could be conducted to companies that implement hedging policies inconsistently. It also applies to companies that have derivatives for speculative purposes because they are considered to have problems with idiosyncratic volatility.…”