What Explains the Bid‐Ask Spread Decline after Nasdaq Reforms?

This paper examines whether the decrease in bid‐ask spreads on Nasdaq after the 1997 reforms is due to a decrease in market‐making costs and/or an increase in market competition for order flows. Unlike previous studies, we jointly examine how competition and trading costs affect bid‐ask spreads. In addition, we separate the effects of informed trading and liquidity costs on bid‐ask spreads. Informed trading cost is directly estimated for each Nasdaq stock using a Bayesian theoretic model. Empirical results show that market‐making costs and competition significantly affect bid‐ask spreads. The post‐reform decrease in bid‐ask spreads is largely due to both an increase in competition and a decrease in informed trading and liquidity costs on Nasdaq.     

Information Asymmetry and the Bid‐Ask Spread: Evidence From the UK

Abstract:   The generally accepted factors that determine the bid‐ask spread are volatility, trading volume and market value ( Atkins and Dyl, 1997 ; Glosten and Harris, 1988 ; and Menyah and Paudyal, 2000 ). Following Kim and Verrecchia (1994) we include a measure of the disagreement in analysts' earnings forecasts in our model of the bid ask spread. This measure serves as a proxy for the informational disadvantage of market makers with respect to informed traders. Market makers respond to the additional risk by increasing the bid‐ask spread. We find that the disagreement amongst analysts is significant for horizons up to and including six months (and with the hypothesised sign) in explaining FTSE 100 company spreads, rendering strong empirical support for our model.     

Relationship Between Analyst Forecast Properties and Equity Bid‐Ask Spreads and Depths Around Quarterly Earnings Announcements

Abstract:   We study the relationships between three variables which proxy for the ex‐ante level of information asymmetry – forecast dispersion, forecast revision volatility, and the level of analyst coverage, and equity bid‐ask spread and depth changes around quarterly earnings releases. Kim and Verrecchia (1994) suggest that earnings releases increase the level of information asymmetry and lower the level of liquidity in the security market. Using both an OLS regression framework and a simultaneous equations model, we examine whether equity bid‐ask spreads increase and depths decrease as the level of information asymmetry increases. Our results indicate that spreads are higher (relative to a non‐event period) around earnings announcements when information asymmetry is more pronounced; however, depths are lower only on the day following the announcement when there is greater information asymmetry. Relative spreads have a significant positive relation with both forecast dispersion and revision volatility and a significant negative relation with analyst coverage. Relative depths have a significant negative relation with forecast dispersion and a significant positive relation with analyst coverage. Our findings indicate that the equity specialist adjusts both spreads and depths when confronting informed traders around earnings releases and that these adjustments are more pronounced when the level of information asymmetry is greater.     

Intra Day Bid‐Ask Spreads, Trading Volume and Volatility: Recent Empirical Evidence from the London Stock Exchange

With the benefit of very high frequency (25 million 1 minute observations) and recent data (2001) for the UK, this paper explores a number of intra day patterns of stock market behaviour. More specifically, a distinct reverse J shaped bid‐ask spread pattern is noted for SETS securities, a declining bid‐ask spread pattern for non‐SETS securities, a two hump pattern for trading volume and a U‐shaped pattern for returns volatility for all securities. In terms of complementing the existing literature, the paper shows that differences in trading systems may affect the bid‐ask spread patterns, while differences in market environments (i.e. US and UK markets) seems to affect the trading volume pattern. The paper suggests avenues for future research, in particular, the need to consider what factors are significant in determining intra day patterns for different trading systems and the need for additional cross‐market comparisons to identify how institutional factors affect the behaviour of investors on an intra day basis.     

Cash flow disaggregation and the prediction of future earnings

We examine the incremental information content of the components of cash flows from operations (CFO). Specifically the research question examined in this paper is whether models incorporating components of CFO to predict future earnings provide lower prediction errors than models incorporating simply net CFO. We use Australian data in this setting as all companies were required to provide information using the direct method during the sample period. We find that the cash flow components model is superior to an aggregate cash flow model in terms of explanatory power and predictive ability for future earnings; and that disclosure of non‐core (core) cash flows components is (not) useful in both respects. Our results are of relevance to investors and analysts in estimating earnings forecasts, managers of firms in regulators’ domains where choice is provided with respect to the disclosure of CFO and also to regulators’ deliberations on disclosure requirements and recommendations.     

Smiles, Bid‐ask Spreads and Option Pricing

Given the evidence provided by Longstaff (1995), and Peña, Rubio and Serna (1999) a serious candidate to explain the pronounced pattern of volatility estimates across exercise prices might be related to liquidity costs. Using all calls and puts transacted between 16:00 and 16:45 on the Spanish IBEX‐35 index futures from January 1994 to October 1998 we extend previous papers to study the influence of liquidity costs, as proxied by the relative bid‐ask spread, on the pricing of options. Surprisingly, alternative parametric option pricing models incorporating the bid‐ask spread seem to perform poorly relative to Black‐Scholes.     

The Long Run Abnormal Performance of UK Acquirers and the Free Cash Flow Hypothesis

Abstract:   Evidence from recent US and UK studies reveals a pattern of poor long run post acquisition performance by acquiring firms. One explanation, due to Jensen (1986) is that acquirers with an excess of free cash flow (FCF) will have a propensity to squander this on wasteful investments, including take‐overs. In this paper, using a dataset of UK take‐overs and proxies for free cash flow similar to those used by Lang, Stulz and Walking (1991) , we find no support for the FCF hypothesis and show that this conclusion is robust to the model of long run returns employed. Contrary to the free cash flow hypothesis there is evidence that acquirers with high free cash flow perform better than acquirers with low free cash flow. Although not consistent with the Jensen hypothesis, this evidence is compatible with the emerging UK evidence that shows cash flow‐to‐price measures are associated with market returns.     

The Opening, Short, Medium and Long Term Performance of Canadian Unit Trust Initial Public Offerings (IPOs)

Abstract:   This paper investigates the initial pricing and performance of Canadian unit trust IPOs over a three‐ to four‐year period and then draws implications for the efficiency of the Canadian market. Overall, the results confirm the following: in the short term, unit trust IPOs are underpriced and outperform the Canadian market; in the medium term, IPOs are fairly priced and neither outperform nor underperform the Canadian market; and in the long term, IPOs are fairly priced but underperform the Canadian market. In addition, our results confirm that the size of underpricing is related to ex‐ante uncertainty about the value of the issue. Ex‐ante uncertainty proxies, namely total risk, exchange listing, relative bid‐ask spread, and relative volume of initial trade, all explain the size of underpricing. When the effects of these factors are controlled, the results confirm that Canadian unit trust IPOs are indeed overpriced in the short term but underpriced in the long term. We conclude that the Canadian unit trust IPO market appears to be inefficient in the short and long term, but over the medium, the market appears to be efficient.     

Accruals, Cash Flows and the Post‐Earnings‐Announcement Drift

Abstract:   Several prior studies have shown that cash flows have significantly greater impact on stock prices than accruals. We examine the implications of these findings for the post‐earnings‐announcement‐drift anomaly. We argue that, if investors under‐react to earnings news, then the larger price impact of cash flows causes the cash flow component of earnings news to predict future returns better than the accruals component. Consistent with this argument, we show that unexpected cash flows are more positively related to future returns, than are unexpected accruals. Also, unexpected cash flows are found to predict future returns above and beyond that predicted by earnings surprises. Finally, we show that a strategy that decomposes earnings news into its components significantly outperforms strategies based on earnings news alone. The results support under‐reaction explanations for the drift.     

Voluntary versus mandatory disclosure of liability insurance coverage limit

This article analyzes the disclosure of the liability insurance coverage limit and the impact of mandating disclosure of the coverage limit in a setting where voluntary disclosure of a firm’s cash flow information is subject to litigation risk and the firm has directors’ and officers’ (D&O) liability insurance. Disclosure of cash flow information is costly, but disclosure of the insurance coverage limit features no direct disclosure friction. We find that, when the litigation environment is weak, the usual unraveling argument applies, and the manager always voluntarily discloses the coverage limit in equilibrium. However, when the litigation environment is strong, either no coverage limit is disclosed or only sufficiently high coverage limits are disclosed in equilibrium. Further analysis shows that mandatory disclosure of the coverage limit increases the voluntary disclosure of cash flow information.     

Mandatory Disclosure,Voluntary Disclosure,and Stock Market Liquidity: Evidence from the EU Bank Stress Tests

We use the EU stress tests and the Eurozone sovereign debt crisis to study the consequences of supervisory disclosure of banks’ sovereign risk exposures. We test the idea that a mandatory one‐time disclosure induces an increase in voluntary disclosures about sovereign risk in the following periods and, through the shift in the voluntary disclosure equilibrium, increases the liquidity of banks’ shares. First, we find that the timing and content of different mandatory disclosure events helps explain the levels of stress‐test banks’ voluntary disclosures about sovereign risk. Second, although the bid‐ask spreads of stress test participants generally increased after the mandatory stress test in 2011, our results suggest that the decrease in market liquidity is entirely attributable to those stress‐test participants that did not commit to voluntarily maintaining the disclosures of sovereign risk exposure.     

The real effects of disclosure regulation: Evidence from mandatory CFO compensation disclosure

The 2006 SEC rule, by changing the definition of Named Executive Officers, mandates CFO compensation disclosure. Using this setting and a difference-in-differences research design, we study the real effects of CFO compensation disclosure regulation on CFO job performance. We hypothesize that the disclosure of CFO compensation information, by facilitating shareholder monitoring of the board in providing appropriate incentives to CFOs, leads to better CFO job performance in providing high-quality financial reports. The analyses support our prediction: the treatment firms, which start disclosing CFO compensation information under the 2006 rule, compared to the control firms, which already disclose CFO compensation before 2006, experience an improvement in CFO performance, as exhibited in decreases in accounting misstatements and unexplained audit fees. The results are more pronounced for firms with concentrated ownership, smaller compensation committees, and CFOs subject to weaker monitoring by audit committees. Overall, we provide evidence of a real effect resulting from mandatory CFO compensation disclosure.     

Information Disclosure and Stock Liquidity: Evidence from Borsa Italiana

This article examines the effect of increased corporate information disclosure on stock liquidity. Using the adoption of International Financial Reporting Standards (IFRS) in Italy as a natural experiment we extend previous work examining the effect on one measure of liquidity—bid‐ask spreads—to others, specifically depth and the price impact of transactions (or effective bid‐ask spreads). Consistent with previous research we find that bid‐ask spreads of stocks decline following the introduction of IFRS, which implies that stock liquidity increases for small traders. However, we also provide evidence that depth at the best quotes declines, which challenges the proposition that liquidity increases for large trades following an increase in disclosure. In additional tests, we find that effective bid‐ask spreads of block trades also decline following the introduction of IFRS. Overall, this evidence confirms that stock liquidity for both small and large trades increases following an increase in corporate information disclosure.     

Managerial conservatism and corporate policies

This paper investigates how conservative managers make corporate decisions. Motivated by psychology research, we use handwritten signatures (i.e., emotionally restraint disclosure styles) as a proxy for CEO conservatism. We find that firms with conservative CEOs engage more with safer investments (capital expenditures), engage less with risky policies (Research & Development expenses and debt financing), hold more cash, are less likely to pay cash dividends, and more likely to use stock repurchase schemes. We use the same proxy for CFO conservatism. We find that CFO conservatism is a better determinant than CEO conservatism for cash holding and financing policies, but the reverse is true for investment policies. Conservative CFOs prefer long-term debt to short-term debt.     

Data breaches and corporate liquidity management

This paper investigates the effects of data breach disclosure laws and the subsequent disclosure of data breaches on the cash policies of corporations in the United States. Exploiting a series of natural experiments regarding staggered state-level data breach disclosure laws, we find that the passage of mandatory disclosure laws leads to an increase in cash holdings. Our finding suggests that mandatory data breach disclosure laws increase the risks related to data breaches. Further, we find firms that suffer data breaches adjust their financial policies by holding more cash as well as decreasing external finance and investment.     

Management of operating cash flows before and after the scandals in the early 2000s: An examination of meeting or beating analyst cash flow forecasts*

We examine whether the stock market premium assigned to meeting or beating analyst estimates of cash flows from operations (hereafter, “CFO”) has changed after the publicized accounting scandals in the early 2000 s (“post-scandals period”). We also examine whether firms’ CFO management behavior associated with meeting or beating analyst CFO forecasts has changed after the scandals. We find that the market reward for firms that meet or just beat analyst CFO forecasts (“small beaters”) has increased in the post-scandals period, especially when the accuracy of CFO forecasts is relatively high. We also find that the extent of CFO management engaged in by small beaters has increased after the accounting scandals and that these firms appear to resort to the timing of CFO. Further, we find evidence that the “underpricing” of CFO is weaker in the post-scandals period that exhibits a greater extent of CFO management than before, suggesting that the reduction in the underpricing of CFO in the post-scandals period is at least partially due to CFO management. Overall, our findings suggest that firms responded to the rising importance of cash flow information after a series of accounting scandals by inflating reported CFO to a larger extent than they did before.     

Write‐Down Timeliness, Line‐of‐Business Disclosures and Investors' Interpretations of Segment Divestiture Announcements

Abstract:   This paper examines investors' anticipation and subsequent interpretations of asset write‐downs accompanying segment divestitures. Examining long‐window returns cumulated over the two years preceding the year of divestiture, we hypothesize and find that investors anticipate write‐downs of segment operating assets before divestiture and recognition occurs, with anticipation conditional on the timeliness of the write‐down and prior disclosure of the segments' operating results under segment reporting rules. Short‐window returns cumulated over the three days surrounding the announcement of the divestiture confirm that investor interpretations of asset write‐downs are similarly contingent on write‐down timeliness and prior disclosure.     

Corporate voluntary disclosure and the separation of cash flow rights from control rights

We find that corporate voluntary disclosure is negatively associated with the separation of cash flow rights from control rights. This result is consistent with the notion that as the separation of cash flow rights from control rights increases, controlling owners have larger incentives to expropriate the wealth of minority shareholders and low corporate disclosure constitutes a mechanism to facilitate controlling owners in masking their private benefits of control. The negative association between voluntary disclosure and the separation of cash flow rights from control rights is less pronounced for firms with greater external financing needs. This result suggests that for firms with high separation of cash flow rights from control rights, those with greater external financing needs undertake higher firm-level voluntary disclosure to reduce information asymmetry. We also find that the negative association between voluntary disclosure and the separation of cash flow rights from control rights is less pronounced for firms that have a large non-management shareholder. Our result supports the role of large non-management shareholder in mitigating agency problems associated with the separation of ownership and control.

An Empirical Investigation of the Effect of CFO Power on Disclosure Quality

We examine the association between chief financial officer (CFO) power and disclosure quality, measured using financial statement disaggregation disclosure and analyst forecast disclosure. Empirically, we validate that CFO power, measured by multiple dimensions, is positively associated with firms’ disclosure quality. We also find that this positive association between CFO power and disclosure quality is stronger when firms exhibit higher governance monitoring and accounting quality. Further analysis shows that our main results hold across multiple disclosure quality tests. Our findings are robust to addressing endogeneity issues using two-stage least squares, Heckman selection bias, and propensity score matching analyses. The results highlight the importance of CFO power for the accounting reporting process and decision-making.     

Bond Selection for Managed Portfolios

Abstract:   Investors in coupon bonds evaluate them based upon financial considerations such as coupon rate, time‐to‐maturity, callability, convertibility, and financial condition of the issuer. These investors regard promised yield as only a rough measure of the reward a bond offers to compensate them for the pure time‐value‐of‐money and the financial risks to which they are exposed. Hence, they need a more meaningful measure of reward to facilitate comparisons among coupon bonds. The purpose of this paper is to describe an alternative heuristic approach to the task of making such comparisons. The approach produces a simple ordinal measure of reward, called the 'indifference spread,' that considers implicitly the potential sources of return to, as well as many of the risks associated with, investment in coupon bonds. For any coupon bond, the indifference spread method permits assessment of relative reward offered for the combined exposures to price and call risks, while also reasonably accommodating possible sale anytime prior to maturity. Once an investor (e.g., money manager) identifies indifference spreads for all bonds under consideration as of any moment in time, he/she can then draw conclusions regarding their relative values at that time based, in large part, on these spreads.