Firm-level idiosyncratic volatility - evidence from the UK market

This thesis attempts to address a number of issues identified in the asset pricing and corporate finance literature in relation to the role of idiosyncratic volatility. These issues include the need to uncover the determinants of idiosyncratic volatility in the UK equity market, examine its association with financial constraints and corporate investment behaviour. The sample used in this thesis provide a comprehensive evidence on the idiosyncratic volatility dynamics of the UK equity market, including firms listed on both the main and the alternative exchange - the Alternative Investment Market (AIM), which was established with a goal of helping small and growing firms to raise capital with less regulatory cost. In light with the findings of extant literature, the results presented in this thesis, reinforces the ability of firm-specific in driving the cross-sectional variation in idiosyncratic volatility for UK firms. Specifically, we find that the aggregate idiosyncratic volatility in the UK financial market has been significantly lower after the 2007-08 global financial crisis, which is a similar trend to that of US. Subsequently, we observe that the crisis has led to a shift in the dynamics of firm fundamentals. Firms with high idiosyncratic volatility after the financial crisis are firms operating in a non-regulated industry, firms that do not pay dividend and those with high book-to-market ratio, small firm size, low earnings, and high previous period volatility. In line with the mosaic of evidence, we suggest that the level of financial constraints faced by a firm is associated with its idiosyncratic volatility. We empirically document that small iv and young firms have high idiosyncratic volatility, and this relationship is strengthened as the financial constraints faced by a firm increases. In other words, financial constraints act as a moderating factor in the firm size-idiosyncratic volatility, firm age-idiosyncratic volatility relationships. The results in this thesis also support the implication of idiosyncratic volatility on corporate investment behaviour. We examine this using a sample of firms listed on the AIM. Our results support that increase in firm-specific uncertainty discourages firms to invest in capital assets as 'real option' value is created by waiting. However, this is not the case for firms with a higher competitive position in the market. Firms with high market share or market power are able to exploit investment opportunities by investing more amidst uncertainty. The tendency of firms with stronger competitive position to extract monopolistic rents demonstrates a strategic response to increased competition. Therefore, effective competition policies in the alternative exchange may encourage firms with average competitive position to stimulate investment activity and thus economic growth.