The option market’s anticipation of information content in earnings announcements

We exploit information in option prices in order to study whether the ex post responsiveness of stock prices to earnings information is reflected from an ex ante, firm- and quarter-specific perspective. Specifically, we develop a measure of anticipated information content (AIC) that isolates the forecasted magnitude of the stock market’s reaction to earnings information. We find that the AIC positively correlates with the ex post magnitude of the stock market sensitivity to unexpected earnings, increases with earnings persistence, firm growth prospects, the richness of firms’ information environments and the presence of (and changes in) sophisticated ownership, and decreases with discount rates. Our paper sheds light on the role that earnings information plays in shaping option-market behavior and offers researchers an option-market approach to studying the responsiveness of stock prices to earnings information.     

Earnings Surprise, Market Efficiency, and Expectations

The examination of both the analysts' consensus and simple forecast models over a single sample provides a better understanding of the link between unexpected earnings and security prices. Analysts' attention is found to reduce the value of the annual earnings announcement to the investor. This suggests that the earnings announcement of firms not followed by analysts contains more information relative to those firms followed by analysts. Further, the examination of the market response to the annual earnings announcement, with respect to either model, fails to detect the pricing anomaly observed in many previous studies.     

The measurement of option mispricing

Different studies have examined the ability of the Black-Scholes option pricing model to estimate accurately market prices of publicly traded options and reached conflicting results. This study examines commonly used ex ante measures of option mispricing, finds that they can produce differing conclusions about option prices, and develops an alternative measure for gauging option mispricing. Empirical analysis of returns to options selected using the various mispricing measures indicates that this new measure is more likely to detect mispricing and identify options that yield excess returns before commissions.     

Mandated accounting changes and debt covenants: The case of oil and gas accounting

The relationships among mandated accounting changes, bond covenants and security prices has been the focus of several studies. These studies have provided mixed evidence on the existence of a bond covenant effect on security prices. This paper suggests that inconclusive prior results are a consequence of inappropriately measuring the default risk of debt. Using an option pricing framework, it is shown that the debt to equity alone is not an adequate measure of default risk. In particular, both the debt to equity ratio and the total risk of the firm are necessary to adequately model the bond covenant effects of an accounting change. These theoretical propositions are supported by the empirical analysis of the security market reaction to changes in oil and gas accounting.     

Short sale constraints,heterogeneous interpretations,and asymmetric price reactions to earnings announcements

This study tests Miller’s (1977) overpricing hypothesis from a new angle. Specifically, we investigate the effects of heterogeneous interpretations on price reactions to earnings announcements. We find that the difference between good news and bad news earnings response coefficients increases with the degree of heterogeneous interpretations in the presence of short sale constraints. This pattern is more pronounced when short sale constraints are more binding. These findings support the notion that, under short sale constraints, stock prices selectively incorporate more optimistic opinions rather than the average opinion of all investors. Therefore, reducing short sale constraints should facilitate price discovery and improve price efficiency. This study complements recent studies examining the joint effect of short sale constraints and ex ante opinion divergence on price reactions to earnings announcements.     

Anticipation of quarterly earnings announcements: A test of option market efficiency

This study tests Chicago Board Options Exchange efficiency by examining option price behavior in the weeks surrounding a firm's quarterly earnings announcement. The evidence presented here suggests that a first-order autoregressive seasonal process describes quarterly earnings behavior and demonstrates that the information content of an earnings announcement is fully incorporated in option prices by the end of the announcement week.     

The incremental information content of non-US GAAP earnings disclosures: Evidence from UK firms

This paper examines price and trading volume responses in the US equity market to the preliminary earnings announcements (PEAs) in the UK of UK firms listed on US exchanges (e.g., NYSE and AMEX). The inquiry focuses on whether the return forecast error (absolute and squared values) and volume residual (standardized and unstandardized) for each day were significantly different from the average on the day of the earnings announcements (PEA). The most significantly unexpected return occurred the day prior to the Financial Times (FT) announcement. The results suggest prompt volume and price responses to the UK PEAs in the US security market. Excess trading volume occurred the day prior to and the day of the FT release price response occurred on the day subsequent to the PEAs. This may suggests that investors possess differential prior beliefs or likelihood functions in evaluating public disclosure. Consistent with Frost and Pownall [Frost, C., & Pownall, G. (1996), Interdependencies in the global markets for capital and information: The case of Smithkline Beecham plc. Accounting Horizons, 1, 38-57], US investors seem not to be confused by US/UK generally accepted accounting principles (GAAP) differences, and in fact use information about UK GAAP earnings in their valuations and trading decisions. This implies that traders correctly use UK accounting output to the determination of values in setting security prices and arriving at trading decisions. Broadly, these findings support the assumption that disclosures by UK-listed firms in their domestic market influence share liquidity and trading in the US market.     

Dealers' Adverse Selection Costs and the Evaluation of Alternative Measures of the Earnings Release Signal

This study investigates the relationship between over-the-counter dealers' adverse selection costs and alternative measures of the earnings release signal to evaluate the quality of the signal. The measure of the earnings release signal most associated with dealers' adverse selection costs is suggested as being the least noisy measure of the information impounded in security prices during earnings release periods. The results suggest that the seasonal Box-Jenkins earnings expectation model known as the Brown-Rozeff “premier” model generates the signal most consistent with the information impounded in security prices during earnings release periods.     

Identifying Factors Consistently Related to Value Line Earnings Predictability

Earnings predictability can affect investment decisions and stock prices. An important source of earnings forecasts for a wide variety of empirical studies has been the Value Line Investment Survey. The purpose of this study is to identify factors that consistently account for cross-sectional differences in Value Line earnings predict-ability. A multivariate model consisting of four company variables and a set of industry indicator variables is used to evaluate the intertemporal consistency of factors related to earnings predictability. Quarterly and annual forecasts are used to measure earnings forecast accuracy. The results by year indicate that one factor, earnings variability, is consistently related to earnings predict-ability.     

Discussion of “Using accounting information for consumption planning and equity valuation”

This paper discusses Yee (2007), who investigates the role of accounting information for consumption planning and equity valuation. Higher earnings quality increases investor welfare and ex ante stock prices as well as the weight on earnings in valuation equations based on both cash flows and earnings. The former is due to improved consumption smoothing through more informed production choices, while the latter is due to the impact on the relative information content of current cash flows versus earnings about future cash flows.     

Stock option compensation and the likelihood of meeting analysts' quarterly earnings targets

One role of stock options in executive compensation packages is to counterbalance the inherently short-term orientation of base salary and annual bonuses. Managerial compensation plans frequently include stock options in order to better align the interests of managers and outside shareholders and reduce agency problems. However, since option values are sensitive to fluctuations in stock prices, and investors reward firms that meet or exceed earnings expectations, executives of firms with sizable option components in their compensation plans have increased incentives to report earnings that meet or exceed analysts' forecasts. We show that the propensity to meet or exceed analysts' quarterly earnings forecasts is positively related to the use of options in top executives' compensation plans. Further, firms that employ relatively more options in their compensation plans more frequently report earnings surprises that exceed analysts' forecast by small amounts (between 0 and 1 cent per share). These results suggest that the use of stock-based compensation intensifies top executives' focus on financial analysts' short-term earnings forecasts.     

The decision relevance and timeliness of accounting earnings in Saudi Arabia

This study examines the decision relevance and timeliness of accounting earnings in Saudi Arabia during the 1995-1999 sample period. The empirical results suggest that the publication of accounting earnings does not cause significant revision to the market assessment of future cash flows of Saudi firms. On the other hand, it appears that the publication of accounting earnings leads individual investors to revise their security holdings. However, this evidence is limited to cases where firms reported profit. The empirical results further suggest that earnings are timely in terms of their association with security returns and that increasing the measurement interval significantly improves this association. The tests also show that positive and negative earnings have differential implications for the timeliness of accounting earnings. Further tests show that this evidence is not consistent with the loss liquidation argument [J. Account. Econ. 20 (1995) 125] and, potentially, may reflect the lack of tax incentives to liquidate investments in loss firms. Finally, the results show that Saudi managers do not incorporate economic losses into accounting earnings on a timely basis which may reflect reduced market demand for accounting information, low levels of public debt, low expected litigation costs, and weak monitoring by analysts and other stakeholders.     

INDEX FUTURES OPTIONS IN AUSTRALIA -AN EMPIRICAL FOCUS ON VOLATILITY

The futures option contract on the Australian All Ordinaries Share Price Index is a relatively new hybrid security that ought to enhance the richness and potential efficiency of security markets. This paper considers the problems of valuing it using the theoretical price of a futures-style option. It was found that there was little consistency between theoretical prices using a number of historical estimates and observed market prices, either intertemporally or between in-the-money or out-of-the-money calls. Further, implied volatility was found to be a decaying function of time and, except at times of instability, did not predict the ex ante futures volatility as well as historic volatility.     

The association between accounting earnings and security returns for large and small firms

The differential information hypothesis advanced by Atiase (1980) states that information production and dissemination by private parties for the purpose of identifying mispriced securities is an increasing function of firm size. This study examines two corollaries of that hypothesis. First, security prices of large firms anticipate accounting earnings earlier than security prices of small firms. Second, for a given level of ‘unexpected’ earnings, the cumulative abnormal returns of small firms exceed those of large firms. The results are generally consistent with Atiase's hypothesis.     

Earnings response coefficients of OECD banks: Tests extended to include bank risk factors

We investigate two issues: Do share prices of banks in European markets respond to unexpected accounting earnings disclosures? Are share prices as well as unexpected earnings changes correlated with bank-relevant risk factors? Results reveal that bank share prices respond to unexpected earnings changes at the time of accounting reports in the same manner as the shares of the more widely-researched non-bank firms. Apart from finding significant earnings response coefficients in eight countries, we find that credit risk, price risk, exchange rate risk, and solvency risk are significantly correlated with share price changes. Third, three bank risk factors are significantly correlated with unexpected earnings changes. These results are obtained after corrections for several statistical and econometric problems so our reported parameters are robust, certainly more so than in earlier studies using ordinary least square regressions. These new findings extend earnings response literature to several banking sectors, and also identify bank's key risk factors.     

Dispersion of Financial Analysts' Earnings Forecasts and the (Option Model) Implied Standard Deviations of Stock Returns

This study examines whether the information implied by simultaneous levels of option and stock prices (specifically, the implied standard deviation of returns) reflects other contemporaneously available information. The independent contemporaneous measure considered is the observed dispersion (across several financial analysts), at a point in time, in the forecasts of earnings per share for a given firm. The results indicate that implied standard deviations clearly reflect the contemporaneous dispersion in analysts' forecasts incrementally, i.e., beyond the information contained in the historical time series of returns.     

The information content of security prices

The study derives a relationship between prices changes and earnings changes by expanding the information upon which earnings expectations are conditioned to include data other than prior earnings history. In particular, price is used as a surrogate for additional information available to market participants. This relationship provides an interpretation of the contemporaneous association between price changes and earnings changes previously observed by Ball and Brown (1968) and Beaver, Clarke and Wright (1979), among others. It also provides a basis for inferring from prices the earnings process and the expected future earnings as perceived by market participants. In doing so, it inverts the familiar price-earnings relationship and uses price as a predictor of earnings. The study differs from previous research which has examined the time series behavior of earnings based solely on previous earnings realizations. This approach can potentially lead to earnings forecasting models that are more accurate than the random walk with a drift that has been robust against challengers. In particular, the evidence indicates that security prices behave as if earnings are perceived to be dramatically different from a simple random walk process. Preliminary evidence also indicates that price-based forecasting models are more accurate than the random walk with a drift model.     

The Relation between Returns and Earnings: Evidence for the UK

This paper presents an empirical study of the explanatory power of annual earnings figures for annual stock returns using UK data. The analysis is performed on a sample of companies, with varying year-ends, over the period 1969–1990. The research exploits Ohlson's recent theoretical contributions to the study of the valuation relevance of accounting information, and it complements a study by Easton and Harris (1991) on US data. Similar to the results of Easton and Harris, the results for the UK provide consistent evidence that both earnings levels and earnings differences have significant explanatory power for security returns. However, unlike Easton and Harris, the evidence from individual year regressions suggests that changes in earnings rather than the level of earnings may be more important in explaining security returns in the UK.     

Theory of the dominant firm: A capital market test

This study provides a test of dominant firm theory by examining earnings-induced information transfers within industries that have a dominant firm. Based on the economic asymmetries between dominant and fringe firms, it is posited that the earnings announcements of dominant firms will act as an industry bell, resulting in a positive association between the unexpected earnings of the dominant firm and the security price changes of the fringe firms. Due to their position as industry followers, the earnings announcements of the fringe firms are not expected to affect the security prices of the dominant firm. The results of empirical tests are generally consistent with dominant firm theory.