Effects of Analysts’ Ratings on Insurer Stock Returns: Evidence of Asymmetric Responses

We examine the information value contained in insurer rating changes. Using a contemporary event study approach, we document an asymmetric reaction of stock prices to rating changes: downgrades cut share prices by approximately 7 percent but upgrades have little significant effect. This result varies across agencies as share prices react more strongly to A.M. Best and Standard & Poor's downgrades than to Moody's. We observe a similar asymmetric reaction to rating changes subject to a common rating benchmark. Finally, we find that prices fall most dramatically when a rating downgrade from one rating agency follows a downgrade from another agency.     

Stock‐Split Post‐Announcement Returns: Underreaction or Market Friction?

We explore the relationship between stock splits and subsequent long‐term returns during the period from 1950 to 2000. We find that, contrary to much previous research, firms do not exhibit positive long‐term post‐split returns. Instead, we find that significant positive returns after the announcement date do not persist after the actual date of the stock split. We also observe that abnormal returns are correlated with the price‐delay or market friction. We conclude that the stock‐split post‐announcement “drift” is only of short duration, and it is attributable to trading frictions rather than behavioral biases.     

The Impact of a Rating Agency's Private Information and Disclosed Causes of Rating Downgrades on Insurer Stock Returns

Existing studies document that bond and insurer rating downgrades are associated with negative abnormal returns but generally do not consider the reasons for the downgrade disclosed or implied in the downgrade announcement. Using hand-collected press releases (downgrade announcements) of A.M. Best Company (Best) for a sample of publicly traded insurance firms during the period 1996–2012, we classify and analyze downgrades based on the disclosed causes of the downgrades and whether the rating agency has implied reliance upon unfavorable private information or opinion. We find that during the three-day event window (?1, +1), rating downgrades overall generate a statistically significant cumulative average abnormal return (CAAR) of negative 7.76%. A significantly more negative CAAR of negative 11.46% is found for “financial-prospects-deterioration” downgrades with the perceived presence of Best's private information or opinion. For downgrades without any indication of Best's private information or opinion, the CAAR is negative 3.35%, which is significantly different from zero but significantly less negative than the CAAR of downgrades where private information or opinion is indicated. Downgrades with reported causes other than deterioration of a firm's fundamental financial performance or condition, such as increases in financial leverage and increased business risk taking, produced statistically significant CAAR of negative 3.19% during the (?1, +1) three-day event window, which is also significantly less negative than the CAAR of downgrades where private information or opinion is indicated. Our results provide evidence that downgrades where private information or opinion is likely and downgrades due to a decline in fundamental financial profiles contain more value-relevant information than other types of downgrades.     

Media heterogeneity and post‐earnings announcement drift: evidence from China

This paper examines how the Chinese stock market acts differently towards state‐controlled and market‐oriented media coverage. Using a setting of post‐earnings announcement drift, we find that information from state‐controlled media enters the stock price in a timelier manner, while the message from market‐oriented media needs more time to get a response from investors. The effect is also influenced by whether the type of news coverage is good or bad. Our findings suggest that the capital market underreacts when good news is reported by the market‐oriented media.     

Effects of Preferred Stock Re-rating on Common Stock Prices: Further Evidence

This study examines the price reactions of common stocks to changes in preferred stock ratings, with focuses on firms with less information available in the market as well as on firms with a relatively larger proportion of preferred stock financing. Emphasis on differential information and the relative size of preferred stocks across firms provide a more powerful test of the effect of rating changes on stock prices. Contrary to previous studies that report no price effect on common stocks due to preferred stock re-ratings, these results show that for low-information firms and for firms with a larger proportion of preferred stocks in their capital structure, a preferred stock rating downgrade exerts significant negative price effect on common stocks during the two-day announcement period. Our findings also have implications for future studies of other firm-specific events such as security offerings, stock repurchases, and convertible calls.     

Retained Asset Accounts and Creditor Reactions to an A.M. Best Change

A variety of research has investigated the impact of rating changes on stakeholder and firm behavior. This article provides a unique setting to analyze the effect for both stock and mutual firms and with a class of nontraditional investors, owners of retained asset accounts (RAAs). These individuals become creditors of the insurer upon receipt of life insurance proceeds, which are held in the general accounts of the insurer. The funds receive limited guaranty fund and no Federal Deposit Insurance Corporation protection, thus subjecting the owner to the financial risk of the insurer. Some owners of RAAs may not understand the risk; thus, it is unclear if these owners act as other creditors to changes in the financial stability of the insurer. This provides a setting to analyze reaction to firm risk, as reflected in ratings changes, to stakeholders other than stockholders or customers. We find that RAA owners do act in a manner consistent with traditional investors. Specifically, we find that abnormal retention in the RAAs indicates significant declines in the level of accounts open and funds deposited in the year following a threshold downgrade (falling below an A–) of the A.M. Best rating.     

Effects of Preannouncements on Analyst and Stock Price Reactions to Earnings News

This study examines the effects of earnings preannouncements on financial analyst and stock price reactions to earnings news. Prior experimental research documents that when the signs of a preannouncement surprise and subsequent earnings announcement surprise are consistent (i.e., both either positive or negative), analysts make larger magnitude revisions to their future period earnings forecasts in response to the total earnings news conveyed in the preannouncement and earnings announcement than when the surprise signs are inconsistent. This study extends this research by examining a sample of actual preannouncements from 1993–1997 to determine whether the effects documented in laboratory settings manifest at the aggregate market level in stock prices and consensus analyst forecast revisions. Results indicate that after controlling for the sign of earnings news, sign of earnings, and sign of the earnings announcement surprise, stock prices and analyst forecast revisions respond more strongly when a preannouncement and subsequent earnings announcement elicit the same surprise signs than when the surprise signs are inconsistent. Further analysis indicates that the consistency of the signs of a preannouncement surprise and earnings announcement surprise is not associated with future earnings, suggesting that the magnified reaction of investors and analysts to consistent surprise signs is not a rational reaction to associations observed in market settings.     

Open‐Market Stock Repurchases by Insurance Companies and Signaling

The signaling hypothesis of share repurchases implies that management uses repurchases to signal either that their firm's future operating performance will improve or that shares of their stock are simply underpriced by the market. This study examines which of the two interpretations can better explain open‐market share repurchase programs announced by insurance companies. We find no evidence that future‐operating performance of insurers improves following the repurchase announcement. In addition, changes in future operating performance cannot explain the announcement‐period abnormal return. Instead, the stock undervaluation prior to the repurchase announcement can significantly explain the announcement‐period abnormal return, particularly for life insurers. Overall, our results suggest that the positive market reaction to insurers’ open‐market share repurchase announcements is due to the stock undervaluation by the market, but not due to positive information content about future operating performance conveyed in the repurchase announcement.     

The Disparate Nature of Targeted Repurchases: Evidence from Long-Run Performance

Abstract:  We examine the announcement stock returns and long-run performance of 352 targeted repurchases from 1979 to 1998. For those repurchases of blocks that are non-control related we find a positive announcement stock price response and positive long-run stock performance indicating that these repurchases are timed to occur when the company's shares are undervalued and that the market underreacts to this signal. In contrast, for those repurchases of blocks that are control related we find a negative announcement stock price response and insignificant long-run stock performance indicating that these repurchases occur for a different reason. We conclude that control related repurchases are utilized solely to dismiss potential takeover bids and are not timed when the stock is undervalued.     

DIRECT EVIDENCE ON THE MARKET‐DRIVEN ACQUISITION THEORY

We provide direct empirical evidence that share overvaluation is an important motive for firms to make stock acquisitions. We find that more overvalued firms are more likely to acquire with stock, and acquirers are more overvalued in successful stock mergers than in withdrawn mergers. Acquirers' overvaluation, on average, exceeds the targets' premium‐adjusted overvaluation. Shareholders of stock acquirers, whose overvaluation is greater than their targets' premium‐adjusted overvaluation, realize sustained wealth gains from one day before the merger announcement up to three years after the merger completion, as compared with a matching sample of similarly overvalued but nonacquiring firms.     

INTRA-INDUSTRY EFFECTS OF BOND RATING ADJUSTMENTS

Several studies find that bond rating downgrades cause negative valuation effects. Other studies find that signals conveyed by earnings releases, earnings forecasts, bankruptcies, and stock offerings of individual firms can be transmitted to their corresponding industries. By combining the two sets of studies, we hypothesize that bond rating changes may contain relevant information not only about the firm, but also about the corresponding industry. We find significantly negative valuation effects for rating downgrades, which are transmitted throughout the industry. Furthermore, we find that intra-industry effects depend on particular characteristics of the bond downgrade, the downgraded firm, and industry rivals. Specifically, the negative intra-industry effects are more pronounced when (1) the downgraded firm experiences a more severe share price response to the bond rating downgrade, (2) the downgraded firm is dominant in the industry, (3) the downgraded firm is more closely related to its rivals in the industry, and (4) the downgrade is due to a deterioration in the firm's financial prospects.     

Investor Inattention and Friday Earnings Announcements

Does limited attention among investors affect stock returns? We compare the response to earnings announcements on Friday, when investor inattention is more likely, to the response on other weekdays. If inattention influences stock prices, we should observe less immediate response and more drift for Friday announcements. Indeed, Friday announcements have a 15% lower immediate response and a 70% higher delayed response. A portfolio investing in differential Friday drift earns substantial abnormal returns. In addition, trading volume is 8% lower around Friday announcements. These findings support explanations of post‐earnings announcement drift based on underreaction to information caused by limited attention.     

The Tax Consequences of Long‐Run Pension Policy*

A firm's pension fund is legally separate from the firm. But because pension benefits are normally independent of fund performance, pension assets impact the firm very much as if they were firm assets. Because they are worth more when times are good and less when times are bad, common stocks in the pension fund add to the sponsoring firm's leverage. They cause contributions to a pension fund to be high just when the firm can least afford to pay them. Conversely, bonds in the pension fund will make it easier for the firm to avoid default on its own bonds when times are bad all over: The more bonds a pension fund buys, the more the firm can borrow. The tax treatment accorded the pension fund differs notably from that accorded the firm. Some have argued that a firm can capitalize on the difference by accelerating the funding of its pension plan. The benefits of full funding are wasted, however, unless the added contributions to the fund are invested in bonds; higher pension contributions now mean lower contributions later, hence higher taxes later. The benefits come from earning, after taxes, the pretax interest rate on the bonds in the pension fund. If the firm wants to take advantage of the differing tax treatment of bonds without altering the level of its current pension contributions, it can (1) sell stocks in the pension fund and then buy bonds with the proceeds while (2) issuing debt in the firm and buying back its own shares with the proceeds. An investment in the firm's own stock creates no more tax liability than an investment in stocks through the pension fund.     

Stock Market Reactions and Information Transfer Due to Financial Instability in the Life Insurance Industry

ABSTRACT: This study examines the stock market reactions and information transfer effects due to financial instability for four life insurance companies that eventually failed or were taken over by regulators. The four companies were First Executive Corporation, First Capital Holdings Corporation, Monarch Capital Corporation, and Mutual Benefit Life Insurance Company. In general, significant negative capital market responses were found after a company released an announcement regarding financial instability. Information transfer effects of a negative announcement by one insurer were not found to have a significant impact on the other insurers. This study complements past studies of contagion effects within the insurance industry.     

How do IMF announcements affect financial markets in crises?: Evidence from forward exchange markets

We employ a theoretical model to interpret the liquidity and moral hazard effects of IMF support during a financial crisis. We then estimate the response of forward exchange markets to IMF-related announcements, using data on the 3-, 9-, and 12-month forward exchange rates. Our results indicate that the announcement of IMF negotiations is associated with a premium on the baht and the rupiah, where the premium is much larger on the latter. This result is largely consistent with the responses of stock and bond markets, especially when country-specific data are employed.     

Determinants of earnout as acquisition payment currency and bidder’s value gains

We examine the wealth effects of a comprehensive sample of UK bidders offering contingent payment, or earnout, as consideration for their acquisitions. We show that bidders using earnout generate significantly higher announcement and post-acquisition value gains than bidders using non-earnout currencies (such as cash, stock exchange, or mixed payments). We construct a logistic model to predict when it is optimal for a bidder to offer earnout. We show that bidders offering earnout optimally enjoy significantly higher announcement and post-acquisition gains than bidders offering non-earnout currencies, consistent with our model of the choice of the optimal method of payment. Overall, we provide robust evidence that earnout is an effective payment mechanism to mitigate valuation risk to acquirers, and also enhances acquirer value during the announcement and post-acquisition periods. Our paper contributes to the broader literature on how corporate acquirers use payment currency to manage information asymmetry and the attendant valuation risk.     

Who Writes the News? Corporate Press Releases during Merger Negotiations

Firms have an incentive to manage media coverage to influence their stock prices during important corporate events. Using comprehensive data on media coverage and merger negotiations, we find that bidders in stock mergers originate substantially more news stories after the start of merger negotiations, but before the public announcement. This strategy generates a short‐lived run‐up in bidders' stock prices during the period when the stock exchange ratio is determined, which substantially impacts the takeover price. Our results demonstrate that the timing and content of financial media coverage may be biased by firms seeking to manipulate their stock price.     

An Anatomy of the “S&P Game”: The Effects of Changing the Rules

This study analyzes the effects of changes in S&P 500 index composition from January 1986 through June 1994, a period during which Standard and Poor's began its practice of preannouncing changes five days beforehand. The new announcement practice has given rise to the “S&P game” and has altered the way stock prices react. We find that prices increase abnormally from the close on the announcement day to the close on the effective day. The overall increase is greater than under the old announcement policy although part of the increase reverses after the stock is included in the index.     

Agency Costs and the Short‐Run Stock Price Response to Capital Expenditures

We estimate the short‐run stock price response to unanticipated capital expenditures. We use association study methodology to avoid the self‐selection bias in event studies and to facilitate construction of a large sample of firm‐years likely to exhibit agency problems. We find that the average price response to routine capital expenditures is negative, and that commonly used agency cost measures explain fully the negative response. Subsample results support the conclusion that the market is skeptical of cash flow financed spending by low‐q firms and even capital spending by high‐q firms when the firm is large and q is only marginally high.     

Volatility spreads and earnings announcement returns

Prior research documents that volatility spreads predict stock returns. If the trading activity of informed investors is an important driver of volatility spreads, then the predictability of stock returns should be more pronounced during major information events. This paper investigates whether the predictability of equity returns by volatility spreads is stronger during earnings announcements. Volatility spreads are measured by the implied volatility differences between pairs of strike price and expiration date matched put and call options and capture price pressures in the option market. During a two-day earnings announcement window, the abnormal returns to the quintile that includes stocks with relatively expensive call options is more than 1.5% greater than the abnormal returns to the quintile that includes stocks with relatively expensive put options. This result is robust after measuring volatility spreads in alternative ways and controlling for firm characteristics and lagged equity returns. The degree of announcement return predictability is stronger when volatility spreads are measured using more liquid options, the information environment is more asymmetric, and stock liquidity is low.