The Role of Volatility in Forecasting

Theories of underinvestment propose a link between cash flow volatility and investment and subsequent cash flow and earnings levels. Consistent with these theories, our results indicate that forecasting models that include volatility as an explanatory variable have greater accuracy and lower bias than forecasting models that exclude volatility. The improvement in forecast accuracy and bias is greatest when the firm is most likely to experience underinvestment. The profitable implementation of a trading strategy based on these findings, however, suggests that equity market participants do not incorporate fully the information in historical volatility when forecasting future firm performance.