The Informational Content and Accuracy of Implied Asset Volatility as a Measure of Total Firm Risk
by Stanislava M. Nikolova of the University of Florida
May 15, 2003
Abstract: Although estimates of asset volatility have been used in a variety of empirical situations, very little is known about their empirical properties. We use a set of 19,020 industrial and 2,014 financial firm-quarter observations to investigate the value of asset volatility estimates as forecasting and risk-assessing variables. First, we construct four alternative asset volatility measures (including one of our own design) for the set of industrial firms. Second, we test the information content of these measures by using them to predict defaults, credit rating changes, and realized asset return characteristics. Third, we apply the insights from these tests in the context of bank regulation to examine whether market prices on bank debt and equity can be used to identify financially weak institutions requiring special supervision. Our preliminary findings indicate that asset volatility estimates successfully forecast defaults and credit-rating downgrades, and that the innovative asset volatility estimate proposed in this study does so better than the more traditional estimates.