Working Paper: CEPR ID: DP8307
Authors: Namho Kang; Pter Kondor; Ronnie Sadka
Abstract: This paper uncovers the changes in the cross-sectional distribution of idiosyncratic volatility of stocks over the period 1963--2008. The contribution of the top decile to the total market idiosyncratic volatility increased, while the contribution of the bottom decile decreased. We introduce a simple theoretical model showing that larger capital of Long/Short-Equity funds further exacerbates large idiosyncratic shocks but attenuates small idiosyncratic shocks. This effect is stronger for more illiquid stocks. Time-series and cross-sectional results are consistent with the predictions of the model. The results are robust to industry affiliation, stock liquidity, firm size, firm leverage, as well as sign of price change. These findings highlight the roll of hedge funds and other institutional investors in explaining the dynamics of extreme realizations in the cross-section of returns.
Keywords: hedge funds; idiosyncratic risk; limits to arbitrage
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Larger capital of long-short equity funds (G23) | Amplifies large idiosyncratic shocks (E32) |
| Larger capital of long-short equity funds (G23) | Diminishes smaller idiosyncratic shocks (E39) |
| Cash flow volatility (G19) | Increases in idiosyncratic volatility for firms in the top decile (E32) |
| Hedge fund ownership (G23) | Negatively impacts the volatility of firms in the bottom decile (G32) |
| Larger capital of long-short equity funds (G23) | Increases contribution of the top decile to total market idiosyncratic volatility (G19) |
| Larger capital of long-short equity funds (G23) | Decreases contribution of the bottom decile to total market idiosyncratic volatility (G19) |