R2 and idiosyncratic volatility: Which captures the firm-specific return variation?

A growing literature regards R-2 and idiosyncratic volatility as interchangeable proxies for firm-specific return variation and examines its relations to information efficiency. However, the question on choosing the appropriate proxy, i.e., R-2 or idiosyncratic volatility, is less investigated. This paper provides alternative evidences that R-2 and idiosyncratic volatility are not interchangeable with the utilization of a unique short selling mechanism in China. Specifically, we mainly find that 1) R-2 is not a satisfied proxy when the information environment for individual firm is improved, while idiosyncratic volatility is a satisfied proxy under the improved information environment; 2) R-2 and idiosyncratic volatility are satisfied proxies for firm-specific return variation when the information environment for individual firm is deteriorated. These results also complement the existing literature on figuring out the appropriate proxy for firm-specific return variation under different information environment. (c) 2016 Elsevier B.V. All rights reserved.