Prof's Work on Investment Risk Wins Praise of Peers
Awards Recognize Contributions to Understanding of Firm-Specific Factors
Dec. 17, 2010
A School of Management finance professor has won two-best paper awards for research articles that advance investors' understanding of the role that risk unique to individual firms plays in the valuation of their stocks and other securities.
Associate Professor Yexiao Xu and his co-authors won the Outstanding Paper Award from the Fifth International Conference on Asia-Pacific Financial Markets, which was held in Seoul, South Korea, Dec. 4.
In their work “When Does Idiosyncratic Risk Really Matter?” Xu and his colleagues from China — Tony Ruan of Xiamen University and Qian Sun of Fudan University — provide new evidence linking idiosyncratic — that is, firm-specific — risk to expected future market returns.
Total risk consists of two components, Xu points out. Systematic — or market — risk can’t be avoided. “But idiosyncratic risk is something we can get rid of by holding a diversified portfolio,” he explains.
That is the view, at least, of how idiosyncratic risk can be handled in a perfect capital market. But researchers are re-examining the perfect market assumption, Xu says, and as they uncover imperfections, they have discovered idiosyncratic risk has not been fully diversified away. That discovery reaffirms the need to assess the role of idiosyncratic risk as a factor in asset pricing.
In his previous award-winning paper — written with Dr. Xuying (Cathy) Cao, associate director of the School of Management’s MS in Finance Program — Dr. Xu showed that in the short term, firm-specific risk relates to short-sell constraints and to arbitrage costs — preventing markets from correcting for possible mispricing. Drs. Xu and Cao also showed that in the long run, firm-specific risk can be priced — that is, measured in terms of its reward for the risk taken. Their paper, “Long-Term Idiosyncratic Volatilities and Cross-Sectional Stock Returns,” earned the pair the best-paper award from the Asian Finance Association at its annual meeting in July.
In the more recent paper, “we look at the importance of idiosyncratic risk on the aggregate level,” Dr. Xu says. “If idiosyncratic risk changes over time and can be priced, it should be able to predict future returns.”
In the work, Dr. Xu and his colleagues propose a novel approach to measure the priced idiosyncratic risk and have devised an econometric method that successfully predicts future market returns using that measure.
Both recent studies build on groundbreaking work Dr. Xu and other colleagues achieved in “Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk” (The Journal of Finance, Volume LVL, No. 1, February 2001). That work, winner of the American Finance Association’s Smith Breeden Prize in 2001, inspired many finance scholars to “become serious in studying the behavior of idiosyncratic risk,” Dr. Xu says.
And both recent papers not only serve to reconcile contradictory results in past asset pricing research that involves idiosyncratic risk but also advance our understanding of the role of idiosyncratic risk, he adds.