How cash flow news is associated with high idiosyncratic volatility stocks?

Abstract

A substantial body of studies addresses the relative importance of cash flow news driving stock returns. Vuolteenaho (2002) documents that this cash flow news is firm-specific information whereas expected return news is a systematic factor. Campbell and Vuolteenaho (2004) empirically find that higher average returns of small and value stock can be explained by their considerably high market cash flow beta. This paper provides a new perspective on cash flow news by linking idiosyncratic volatility with cash flow news. Applying a vector autoregressive (VAR) model based on Vuolteenaho (2002), I examine how firm characteristics are associated with the risk of cash flow news. I find three main results. First, even if total variance of firm-level stock returns are mainly driven by cash flow news variance regardless of firm characteristics, this variance is particularly larger in smaller, lower book-to-market, and higher idiosyncratic volatility stocks. Second, high idiosyncratic volatility stocks have low market cash flow beta but high cash flow news variance. Third, although high idiosyncratic volatility stocks earn lower returns than low idiosyncratic volatility stocks, their market cash flow betas rather yield positive effect on stock returns while cash flow betas of small and value stocks negatively affect stock returns.