Stochastic Idiosyncratic Operating Risk and Real Options: Implications for Stock Returns

We show that introducing stochastic idiosyncratic operating risk into an equity valuation model of firms with growth options explains two empirical results related to idiosyncratic volatility: the positive contemporaneous relation between stock returns and changes in idiosyncratic return volatility, and the poor performance of stocks with high idiosyncratic volatility. The model further predicts that (i) returns correlate positively with idiosyncratic volatility during intervals between large changes in idiosyncratic volatility (the switch effect), (ii) and that the return relations and the switch effect are stronger for firms with more real options and which undergo larger changes in idiosyncratic volatility. Empirical results support these predictions.