Review of Accounting Studies, 7, 195–215, 2002
2002 Kluwer Academic Publishers. Manufactured in The Netherlands.
The Role of Volatility in Forecasting
BERNADETTE A. MINTON
Ohio State University
CATHERINE M. SCHRAND
University of Pennsylvania
BEVERLY R. WALTHER
Abstract. Theories of underinvestment propose a link between cash ﬂow volatility and investment and subsequent
cash ﬂowand 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.
Keywords: cash ﬂow, forecasting, underinvestment, volatility
JEL Classiﬁcation: G31, G35, M41, G19
Theories of risk management propose a relation between volatility and investment levels. In
the presence of market imperfections, external capital is more costly than internal capital and
cash ﬂow volatility is associated with underinvestment (see Myers, 1977). Higher volatility
leads to periods in which the ﬁrm has insufﬁcient cash ﬂow to fund its “desired” investment.
The result is a lumpy investment pattern over time and a reduction in expected future
cash ﬂow and earnings levels (Froot, Scharfstein and Stein, 1993; Smith and Stulz, 1985).
Minton and Schrand (1999) document a negative relation between cash ﬂow volatility and
investment, suggesting that ﬁrms with more volatile cash ﬂows are more likely to experience
internal cash ﬂow shortfalls and forgo investment. Exacerbating the effect of volatility on
underinvestment is the fact that ﬁrms with more volatile cash ﬂows or earnings are more
likely to experience a greater external cost of capital (Minton and Schrand, 1999).
Despite the hypothesized link between volatility and future cash ﬂow and earnings, fore-
casting models in prior research traditionally include only historical cash ﬂow and earnings
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