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Working Paper

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The volatility of share returns for individual companies increased sharply during the recent financial crisis. The larger part of this increase was due to a dramatic rise – five fold as measured by variance – in idiosyncratic risk. We find that this pattern repeats itself during each major economic reversal going back 85 years. Because idiosyncratic risk is what is involved, this increase cannot be explained by changes in predictions concerning the future course of the economy as a whole.

Our first goal is to explain why difficult economic times, which are defined in terms of market wide phenomena, make the future of individual firms more difficult to predict, above and beyond the effects of the more difficult to predict economy as a whole. One explanation is that in crisis times, information about a firm contained in current news may become more important, compared to ordinary times, in predicting its future cash flows relative to the role of the already existing stock of knowledge relevant to making such predictions. A second is that the quality of management becomes more important in crisis times; consequently, the ordinary flow of information about this subject can have bigger impact. A third is that crisis may create uncertainty as to what factors are even important to valuation; because of uncertainty, a broader range of information may be seen to shed light on this question, and therefore move stock prices. We find less convincing two other possible explanations: noise trading and the idea that the increase in idiosyncratic risk is the result of a bad-times-induced separating equilibrium that reveals which firms have fraudulent or inept managers who were able to mask their problems in the preceding good times and which firms have been genuinely well managed all along.

Our second goal is to explore the implications of our results for corporate and securities litigation, which, over the last few decades, has become increasingly enmeshed with the empirical analysis of the idiosyncratic portion of share returns of the companies involved. In this connection, we consider the determination of loss causation in fraud-on-the-market class actions, the determination of materiality necessary for a trade on non-public information to violate the law, the determination of what items of information should be subject to a mandatory disclosure, and the extent of deference that should be paid to a corporate board that reject acquisition offers at a premium above pre-offer market price. In each of these areas, we find that there are no simple answers to the question of whether the increase in idiosyncratic risk during periods of crisis would justify a change in practice.