Earnings Announcements and the Components of the Bid-Ask Spread

This study investigates the behavior of the components of the bid-ask spread around earnings announcements. We find that the adverse selection cost component significantly increases surrounding the announcements, while the inventory holding and order processing components significantly decline during the same periods. Our results suggest that the directional change in the total bid-ask spread depends on the relative magnitudes of the changes in these three components. Specifically, the decreases in inventory holding costs and order processing costs imply that earnings announcements may have an insignificant impact on the total bid-ask spread, even when they result in increased information asymmetry.     

Information Asymmetry Around Earnings Announcements

This study examines bid-ask spreads to determine how the anticipation and release of earnings announcements affect information asymmetry in the stock market. I use regression analysis and find that bid-ask spreads are negatively related to public information availability and positively related to earnings variability and the market reaction to prior unexpected earnings. The results suggest that firms for which earnings is expected to yield a relatively larger stock market reaction have greater information asymmetry than firms for which earnings are expected to yield a smaller market reaction.I also find that bid-ask spreads gradually increase in the four days prior to earnings announcements, and increase sharply the day prior to, the day of and the day after the earnings announcements. Bid-ask spreads seven to ten days after earnings announcements are not significantly different from bid-ask spreads seven to ten days prior to earnings announcements.     

The effect of option transaction costs on informed trading in the options market around earnings announcements

We investigate the effect of option market transaction costs (a form of market imperfection) on the ability of option implied volatility-based measures to predict future stock returns and volatility around quarterly earnings announcements. We find that the predictability is significantly stronger for firms with lower option relative bid-ask spreads. The effect is more pronounced around positive rather than negative earnings news. We find no significant effect of option transaction costs around randomly chosen dates when there is no clustering of major information events. Trading strategies based on option market predictors and transaction costs earn monthly abnormal returns of 1.39% to 1.91%.     

Management earnings forecast disclosure policy and the cost of equity capital

We examine the relation between management earnings forecast disclosure policy and the cost of equity capital in a cross-section of 1,355 firms over a 4-year post-Regulation Fair Disclosure period (2001 through 2004). We find evidence of a negative association between the quality of management earnings forecasting policy and cost of equity capital, and we document that the strength of the association is greater for firms with higher disclosure costs and for firms with more relevant quarterly management earnings forecasts. Our results are robust to the use of multiple methods to address both endogeneity and the measurement error in firm-specific estimates of implied cost of equity capital.     

BID-ASK SPREAD COMPONENTS AROUND ANTICIPATED ANNOUNCEMENTS

In this paper I re-examine spreads around dividend and earnings announcements and provide new evidence on patterns by examining the components of the bid-ask spread. Transaction data are examined through a recently developed spread decomposition model that decomposes the bid-ask spread into a fixed (execution) component and an adverse selection component. In addition, this model does not rely on a constant spread as previous spread decomposition models require. The results show that around earnings announcements, the bid-ask spreads and spread components have significant changes indicating that the anticipated announcement is informative. However, the actual public announcement of a dividend does not alter the bid-ask spread and spread components of actively traded securities.     

Do accruals exacerbate information asymmetry in the market?

A considerable body of evidence, both archival and experimental, suggests that accounting accruals are heterogeneously interpreted by investors. We examine whether the information asymmetry among investors arising from this heterogeneous interpretation, implied in these empirical results, affects transactions costs in the form of the adverse selection component of the bid-ask spread. We examine this impact both, in a yearly setting and around the first release of quarterly accrual information. The results of the study provide empirical evidence of a positive association between the adverse selection component and accruals in the yearly analysis. Since wider bid-ask spreads are both theoretically and empirically linked to higher stock returns (Brennan & Subrahmanyam, 1996), our results provide a transaction cost basis for understanding one possible factor underlying the linkage between accruals and cost of equity capital, and accruals and information risk pricing as documented in Francis et al. (2005) and Ecker et al. (2006).     

The economic benefits of FASB's recommended disclosures: Evidence from the pharmaceutical industry

Prior research has documented an association between disclosure quality and various economic benefits, most notably between the cost of equity capital and market liquidity. We extend this literature by investigating whether pharmaceutical firms that comply with recommended voluntary disclosures of the Financial Accounting Standards Board (FASB) exhibit lower bid-ask spreads, greater market depth, and lower cost of equity capital. Cross-sectional analysis using pharmaceutical firms reveals a negative association between disclosure quality and bid-ask spreads (both the total spread and its adverse-selection component), but no association between disclosure quality and either market depth or the ex ante cost of equity capital. Overall, our findings provide some evidence of benefits accruing to pharmaceutical firms that comply with the FASB's recommended voluntary disclosures under the assumption that lower bid-ask spreads reduce the cost of capital and strong evidence that complying with FASB's recommended disclosures provide a direct benefit to small investors, those who bear the entire weight of bid-ask spreads.     

Liquidity skewness in the London Stock Exchange

We study liquidity on the London Stock Exchange. We find that the average bid-ask spread declines, but that the skewness of the spread increases. These results are robust to firm size, trading volume and price level. Our findings hold when the bid-ask spread is estimated utilising high frequency data. We find that the bid-ask spread prior to earnings announcements dates is significantly higher than that of post earnings announcements, suggesting that asymmetric information has driven the increase in liquidity skewness. We also find that the effect of earnings announcements is more pronounced in the 2007 global financial crisis, consistent with the notion that extreme market downturns amplify asymmetric information. Our overall evidence also implies that increased competition and transparent trading environments limit market makers' abilities to cross-subsidize bid-ask spreads between periods of high and low levels of asymmetric information.     

Cooking the books: Recipes and costs of falsified financial statements in China

We examine the causes and consequences of falsified financial statements in China. Using bivariate probit regression analysis, we find that firms with high debt and that plan to make equity issues are more likely to manipulate their earnings and thus have to restate their financial reports in subsequent years. We also find that corporate governance structures have an effect on the occurrence and detection of financial fraud. There are significant negative consequences to fraudulent financial statements. Restating firms suffer negative abnormal stock returns, increases in their cost of capital, wider bid-ask spreads, a greater frequency of modified audit opinions, and greater CEO turnover. We also find that firms located in highly developed regions suffer more severe consequences when they manipulate their accounts.     

Financial Restatements, Cost of Debt and Information Spillover: Evidence From the Secondary Loan Market

Abstract:  In this paper, we investigate the effect of financial restatements on the debt market. Specifically, we focus on the secondary loan market, which has become one of the largest capital markets in the US, and ask the following: (1) whether financial restatements increase restating firm's cost of debt financing and (2) whether the information about restatements arrives at the secondary loan market earlier than at the stock market? Using 176 restatement data, we find significant negative abnormal loan returns and increased bid-ask spreads around restatement announcements. Furthermore, this negative loan market reaction is more pronounced when the restatement is initiated by either the SEC or auditors, and when the primary reason for restatement is related to revenue recognition issues. Additionally, we find restatement information arrives at the secondary loan market earlier than at the equity market, and that such private information quickly flows into the equity market. We also show that stock prices begin to decline approximately 30 days prior to the restatement announcements for firms with traded loans. However, we do not find such informational leakage for firms without traded loans. Collectively, the results of this paper suggest: (1) increased cost of debt financing after restatements and (2) superior informational efficiency of the secondary loan market to the stock market.     

Quarterly earnings announcements and intra-industry information transfer from the Pacific to the Atlantic

In this study, we explore intra-industry information transfer of quarterly earnings announcements for six major developed markets including the United States. Using an event study methodology, we find that the average cumulative abnormal returns (CARs) of peer firms exhibit a positive and significant relationship with the CARs of announcing firms in the same country and industry over the three-day window surrounding quarterly earnings announcements. During periods of high past market volatility, earnings announcements demonstrate magnified information spillover effects on peer firms. Also, our results suggest that announcing firms with larger market capitalization generate greater intra-industry information transfer.     

The information content of earnings announcements: new insights from intertemporal and cross-sectional behavior

This study examines the information content of quarterly earnings announcements, measured as the magnitude of stock price revision at earnings announcements relative to price revision at other times. We investigate whether quarterly earnings announcements are informative using a nonparametric approach and 1971–2011 sample period. The findings affirm prior evidence on earlier sample periods that significantly more information is conveyed to investors in the three days around earnings announcements than in randomly chosen three-day periods. Next, we examine the behavior of information content over our sample period and document four key findings. First, there is a dramatic increase in information content at earnings dates from 2001 onward. Second, the market reaction to loss firms is substantially less than that for profitable firms. Third, there is a significantly greater reaction to larger firms. Fourth, reaction at earnings dates is significantly increasing in analyst coverage, and once analyst coverage is controlled, the association with size becomes less significant.     

Information Asymmetry and the Dealer's Bid-Ask Spread: A Case Study of Earnings and Dividend Announcements

Recent theoretical work on the bid-ask spread asserts that the dealer should widen the bid-ask spread when he or she suspects that the information advantage possessed by informed traders has increased. Thus, the dealer's spread can be employed to test for an increase in information asymmetry prior to an anticipated information event. In this paper, the method is applied to earnings and dividend announcements, which have been documented to be information events. The authors study three groups of announcements: (a) joint announcements—i.e., earnings and dividend announcements that are made on the same day, (b) initial (first) announcements—earnings or dividend announcements that were not preceded by another announcement in the prior thirty days, and (c) following (second) announcements—those announcements that follow the first announcement by at least ten days but by no more than thirty days. The authors find a strong increase in information asymmetry only before the second announcements and virtually no increase before the joint and first announcements. This is consistent with the hypothesis that there is, on average, normal information asymmetry before announcements, but that the dealer will suspect a nonroutine announcement (with an attendant increase in information asymmetry) when the second announcement is separated from the first by more than ten days. Other possible explanations for the results are discussed, and suggestions for future research are outlined.     

Dual-class versus single-class firms: information asymmetry

I examine information asymmetry in dual-class firms in general and when they need (do not need) additional external capital. In general the results show that dual-class firms have higher information asymmetry than single-class firms. When dual-class firms need additional external financing, the gap in information asymmetry between dual-class firms and single class firms is narrower. I find that as the need of additional external capital increases, the difference in information asymmetry between dual-class and single-class firms decreases (consistent with increased disclosures). It decreases, up to a point that there is no difference in information asymmetry with single-class firms that also needs additional external capital. When using adverse selection component of bid-ask spread, the paper finds that as the need of external financing gets high, dual-class firms show lower information asymmetry 1 year before they need additional external capital.     

‘Hot’ Debt Markets and Capital Structure

This paper examines the motives of debt issuance during hot‐debt market periods and its impact on capital structure over the period 1970–2006. We find that perceived capital market conditions as favourable, an indication of market timing, and adverse selection costs of equity (i.e., information asymmetry) are important frictions that lead certain firms to issue more debt in hot‐ than cold‐debt market periods. Using alternative hot‐debt market issuance measures and controlling for other effects, such as structural shifts in the debt market, industry, book‐to‐market, price‐to‐earnings, size, tax rates, debt market conditions and adjustment costs based on debt credit ratings, we find that firms with high adverse selection costs issue substantially more (less) debt when market conditions are perceived as hot (cold). Moreover, the results indicate that there is a persistent hot‐debt market effect on the capital structure of debt issuers; hot‐debt market issuing firms do not actively rebalance their leverage to stay within an optimal capital structure range.     

Property crime,earnings variability,and the cost of capital

We show that firms located in states where property crime is more prevalent have more uncertain earnings and higher financing costs. Specifically, firms located in states with higher property crime rates have more volatile and less persistent earnings as well as lower quality analysts' earnings forecasts. Firms located in states with higher property crime rates also have a higher cost of equity and debt capital. These results are robust to accounting for econometric and endogeneity concerns in various ways. Overall, our results suggest that a potentially large and overlooked cost of crime is a higher cost of capital.     

Voluntary disclosure and the cost of equity capital: Evidence from management earnings forecasts

This paper examines the directional effects of management earnings forecasts on the cost of equity capital. We find that forecasters of bad news experience a significant increase in the cost of equity capital in the month after their disclosure. Conversely, the cost of equity capital for good news forecasters does not change significantly in the same period. We also indicate that the magnitude of changes in the cost of capital for good news forecasters is significantly lower than that for bad news forecasters and non-forecasters, which suggests that investors may view good news forecasts less credible. Finally, we show that the effect of the subsequent earnings announcement on the cost of equity capital is preempted by the management forecasts for bad news firms, and that the combined effects of the management earnings forecasts and the earnings announcement are not significant for both good news and bad news forecasters. Our paper contributes to the literature by adding evidence on directional effects of voluntary disclosures and on long-term economic consequences of management earnings forecasts.     

More than meets the eye: Convertible bond issuers' concurrent transactions

We document that, in recent years, over 60% of convertible bond issuers conduct concurrent transactions including share repurchases, call option purchases, warrant sales, seasoned equity offerings, and stock lending program initiations. We investigate the determinants of issuers' choice of concurrent transactions and find that a proxy for capital supply (flows to convertible bond arbitrage hedge funds) is a significant determinant. Option purchases are more likely when capital supply is low and the convertible is dilutive to earnings. SEOs are more likely when firms have valuable growth opportunities and capital supply is low. Convertible issuers establish lending programs when arbitrageurs likely encounter difficulty shorting their stock, suggesting that these firms facilitate short selling in their own stock. These results suggest that, in the convertible bond market, the influence of capital supply extends beyond the issuance decision to the use of concurrent transactions and that these transactions offer important flexibility to issuers. We find that average equity market announcement effects differ when issuers conduct concurrent transactions. Consistent with models of adverse selection, concurrent transactions that reduce the dilutive impact on earnings, thereby making the design more debt-like, are associated with less negative announcement effects. Conversely, concurrent transactions that increase the dilutive impact on earnings, thereby making the design more equity-like, are associated with more negative announcement effects.     

Accounting quality,information risk and the term structure of implied volatility around earnings announcements

We examine the association between accounting quality, which is used as a proxy for firm information risk, and the behavior of the term structure of implied option volatility around earnings announcements. By employing a large sample of US firms having options traded on their equity during 1996–2010, we find that lower (higher) accounting quality is significantly associated with stronger (weaker) changes in the steepness of the term structure of implied volatility curve around quarterly earnings announcements. This finding (which is robust to controls for business-stemming uncertainty regarding future firm performance) is consistent with a stronger differential of short vs. long-term uncertainty for higher information risk firms, indicating greater uncertainty on the future economic performance of poorer vs. stronger accounting quality firms. We also establish the trading implications of these findings by demonstrating a (profitable in-sample) self-financed option trading strategy that is based on the quality of the accounting information released on earnings announcement days.     

The Changing Asymmetric Information Component of REIT Spreads: A Study of Anticipated Announcements

This study examines the risk-compensating behavior of REIT market makers. The bid-ask spread is hypothesized to compensate market makers for three costs: asymmetric information, order processing, and inventory. As the market makers perceived likelihood of transacting with a better-informed individual increases (decreases), the percentage of the spread that is attributed to asymmetric information will increase (decrease). This study examines the asymmetric information component of the bid-ask spread immediately prior to and following REIT dividend announcements and REIT funds from operations announcements during 1995 and 1996. The asymmetric information component increases the day before and then declines subsequent to dividend announcements of small and equity REITs. Asymmetric information costs increase following funds from operations announcements.