Does Volatility Improve UK Earnings Forecasts?

Abstract:  We investigate the relation between UK accounting earnings volatility and the level of future earnings using a unique sample comprising some 10,480 firm-year observations for 1,481 non-financial firms over the 1985–2003 period. The findings confirm the in-sample result of an inverse volatility-earnings relation only for the 1998–2003 sub-period and for the most profitable firms. The out-of-sample forecast accuracy for the top earnings quintile improves when volatility is added as a regressor to a model including only lagged earnings. The findings are consistent with the over-investment hypothesis and the view that the earnings of the most volatile firms tend to mean revert more rapidly.     

Information Content of Interim Earnings Components—Evidence from Finland

This study examines the information content of the interim earnings of listed Finnish firms. The degree of association between returns and interim earnings is studied. The assumption is that, compared to transitory changes, permanent changes in earnings have a greater association with returns. Unexpected returns are regressed over unexpected permanent earnings and unexpected transitory earnings. Three return measurement periods are used to examine any potential asynchrony between prices and earnings. To reduce the errors-in-variables problem expected in single-security-level studies, observations are grouped into portfolios. When the data are divided into portfolios, the results give evidence of the association as hypothesized.     

Permanent and Transitory Earnings,Accounting Recording Lag,and the Earnings Coefficient

In this paper, (1) wedefine precisely the terms permanent and transitory earnings;(2) we delineate the effects of the degree of permanence andof accounting recording lag on estimates of the slope coefficientfrom a returns-earnings regression and (3) we examine the relationbetween the estimates of the earnings coefficient and observablevariables that may indicate (i) the extent to which earningsare more or less permanent, and (ii) the extent to which valuerelevant events are recorded in accounting earnings in a timelyfashion. Our main point is that attributing differences in thereturns-earnings relation to one of these effects without controllingfor the other may lead to erroneous conclusions.     

The Variability of Earnings and Non-Earnings Information and Earnings Prediction

This paper examines the performance of a 'composite' model of earnings prediction that integrates current earnings and current price as predictors of next year's earnings. The results show that current earnings (current price) play a key role in predicting future earnings when the ratio of earnings variance to price variance is low (high). The composite model is superior to univariate time-series models in out-of-sample predictive accuracy for the overall sample, and is substantially so for the group of firms with a high ratio of earnings variance to price variance.     

How Persistent is Stock Return Volatility? An Answer with Markov Regime Switching Stochastic Volatility Models

Abstract:  We propose generalised stochastic volatility models with Markov regime changing state equations (SVMRS) to investigate the important properties of volatility in stock returns, specifically high persistence and smoothness. The model suggests that volatility is far less persistent and smooth than the conventional GARCH or stochastic volatility. Persistent short regimes are more likely to occur when volatility is low, while far less persistence is likely to be observed in high volatility regimes. Comparison with different classes of volatility supports the SVMRS as an appropriate proxy volatility measure. Our results indicate that volatility could be far more difficult to estimate and forecast than is generally believed.     

Estimation and Prediction of a Non-Constant Volatility

In this paper we study volatility functions. Our main assumption is that the volatility is a function of time and is either deterministic, or stochastic but driven by a Brownian motion independent of the stock. Our approach is based on estimation of an unknown function when it is observed in the presence of additive noise. The set up is that the prices are observed over a time interval [0, t], with no observations over (t, T), however there is a value for volatility at T. This value is may be inferred from options, or provided by an expert opinion. We propose a forecasting/interpolating method for such a situation. One of the main technical assumptions is that the volatility is a continuous function, with derivative satisfying some smoothness conditions. Depending on the degree of smoothness there are two estimates, called filters, the first one tracks the unknown volatility function and the second one tracks the volatility function and its derivative. Further, in the proposed model the price of option is given by the Black–Scholes formula with the averaged future volatility. This enables us to compare the implied volatility with the averaged estimated historical volatility. This comparison is done for three companies and has shown that the two estimates of volatility have a weak statistical relation.     

Earnings Smoothing,Cash Flow Volatility,and CEO Cash Bonus

Prior studies generally relate managers’ decisions to smooth earnings to their desire to maximize their overall compensation and to smooth their consumption. However, earnings smoothing could also be driven by the firm's expected benefits from reporting a smooth earnings stream. Our paper provides empirical support for the latter explanation of earnings smoothing. Specifically, we find that while CEO bonus on average increases with earnings smoothing, the increase is larger when the firm's cash flow volatility is higher. Further, CEO bonus is shielded from the negative effects of lower earnings arising from the need to report a smoother earnings stream.     

An Empirical Analysis of the Volatility in the Open-End Fund Market: Evidence from China

This paper applies a set of GARCH models to investigate the three characteristics, including time persistence, leverage effect, and risk premium, of the volatilities of the four China Securities Index (CSI) fund indices. This study made the following four findings: (1) a strong ARCH effect exists in the returns; (2) time persistence is significant in all the CSI fund indices, namely, "stock index," "hybrid index," and "bond index" in descending order of significance; (3) the leverage effect is not statistically significant, yet there may be a positive leverage effect on the bond funds; (4) a risk premium effect exists in the open-end fund market, especially in the bond fund market.     

Forecasting Credit Spread Volatility: Evidence from the Japanese Eurobond Market

Different approaches to forecasting the volatility associated with the credit spreads on Yen Eurobonds are investigated. The actual volatility, historical volatility and estimated conditional volatility on spreads derived from a regression-based model with a GARCH and ARMA specification are compared within an adaptation of Black’s (J. Finance, 31, 1976, 361–367) option-pricing model. Surprisingly, the regression forecast over a medium forecasting horizon suggests that historic volatility provides the better forecast. The implications of these results for volatility forecasting and credit spread modelling are also discussed.JEL Classification: C32; G15     

Earnings, Cash Flows and Security Returns Over Long Return Intervals: Analysis and UK Evidence

The aim of this paper is to provide a fuller understanding of the process linking security returns and accounting data by focusing on the effect of long return intervals on the association between security returns and earnings and cash flow variables. First, we develop a theoretical basis for empirical analysis of the relationship between security returns and cash flow data over long return intervals. Second, we carry out empirical analysis of both the information content of cash flow variables and the incremental information content of accounting earnings and cash flows using UK data over the period 1985–92 for annual, two year and four year return intervals. Our results provide strong evidence of the valuation relevance of cash flow information for the dataset examined.     

Time‐Varying Volatility in the Foreign Exchange Market: New Evidence on its Persistence and on Currency Spillovers

We examine empirically the volatility of four major US dollar spot exchange rates using intraday data over 40 trading days. Using multivariate stochastic volatility models, we investigate the degree of persistence of exchange rate volatility for data sampled at different frequencies and the role of volatility spillovers across exchange rates. We find that the noise component of volatility 'aggregates out' very quickly, being dominated by the more persistent component of volatility for data sampled at 15–minute or lower frequencies. Our results also suggest that exchange rate volatility is very persistent and that cross–currency spillovers are small.     

Asset Disposal as a Method of Real Earnings Management: Evidence from the UK

We examine asset sales as a method of real earnings management around the benchmarks of loss avoidance and last year's earnings. Evidence is reported of asset sales to boost or reduce earnings near the benchmark of last year's earnings. For the zero earnings benchmark our results are moderated by the opening balance of accruals: only firms with high levels of accruals use asset sales to boost earnings to avoid a loss and only firms with low levels of accruals use asset sales as part of a big bath. We suggest that firms with high accrual balances find it difficult to use additional income-increasing accruals but find it more convenient to write off accruals rather than sell assets to artificially reduce earnings. International Financial Reporting Standards (IFRS) are associated with reduced use of asset sales for gains and especially with reduced asset sales for losses. We ascribe this to IFRS introducing additional judgement and estimation in relation to the valuation of both long-lived and current assets on a recurring basis.     

Model-free versus Model-based Volatility Prediction

The well-known ARCH/GARCH models for financial time series havebeen criticized of late for their poor performance in volatilityprediction, that is, prediction of squared returns.¹ Focusingon three representative data series, namely a foreign exchangeseries (Yen vs. Dollar), a stock index series (the S&P500index), and a stock price series (IBM), the case is made thatfinancial returns may not possess a finite fourth moment. Takingthis into account, we show how and why ARCH/GARCH models—whenproperly applied and evaluated—actually do have nontrivialpredictive validity for volatility. Furthermore, we show howa simple model-free variation on the ARCH theme can performeven better in that respect. The model-free approach is basedon a novel normalizing and variance–stabilizing transformation(NoVaS, for short) that can be seen as an alternative to parametricmodeling. Properties of this transformation are discussed, andpractical algorithms for optimizing it are given.     

The Articulation of Returns and Accounting-Related Variables when Returns Lead Earnings: UK Evidence

This paper constructs a simple setting in which economic returns always lead accounting earnings. It then uses this setting to explore analytically the likely effect of 'returns leading earnings' on the properties of the market-to-book ratio, accounting profitability, the price-earnings ratio and profitability persistence. The analysis predicts that 'returns leading earnings' will tend to drive up the level of each of the three accounting-related ratios and will generate certain patterns of association between those ratios. Analysis of data from a sample of UK companies supports many of the predictions.     

Volatility as an Asset Class: European Evidence

Abstract

Volatility movements are known to be negatively correlated with stock index returns. Hence, investing in volatility appears to be attractive for investors seeking risk diversification. The most common instruments for investing in pure volatility are variance swaps, which now enjoy an active over-the-counter (OTC) market. This paper investigates the risk-return tradeoff of variance swaps on the Deutscher Aktienindex and Euro STOXX 50 index over the time period from 1995 to 2004. We synthetically derive variance swap rates from the smile in option prices. Using quotes from two large investment banks over two months, we validate that the synthetic values are close to OTC market prices. We find that variance swap returns exhibit an option-like profile compared to returns of the underlying index. Given this pattern, it is crucial to account for the non-normality of returns in measuring the performance of variance swap investments. As in the US, the average returns of selling variance swaps are found to be strongly positive and too large to be compatible with standard equilibrium models. The magnitude of the estimated risk premium is related to variance uncertainty and past index returns. This indicates that the variance swap rate does not seem to incorporate all past information relevant for forecasting future realized variance.     

Earnings manipulation and similarity of annual report disclosure: Evidence from China

The Management Discussion and Analysis (MD&A) section is an important component of a company's annual report, where the management team provides a textual analysis of the company's performance for investors. Due to the existence of agency problems, management is likely to mask any earnings manipulation in order to maximise their salary, build a corporate empire or obtain more financing, which will reduce the reliability of the company's financial information. Utilising 13,679 Chinese A-share listed companies from 2008 to 2020, this study examines the correlation between management earnings manipulation and annual report MD&A similarity. We find that earnings manipulation leads to increased MD&A similarity in order to reduce the transmission of useful information and thus stymie investors. As such, we recommend that regulatory authorities should monitor the level of similarity and validity of MD&A disclosures in addition to the authenticity of numerical financial information.     

Conditional Persistence of Earnings Components and Accounting Anomalies

We suggest that the failure of investors to distinguish between an earnings component's autocorrelation coefficient (unconditional persistence) and the marginal contribution of that component's persistence to the persistence of earnings (conditional persistence) provides a partial explanation of post‐earnings‐announcement drift, post‐revenue‐announcement drift, and the accrual anomaly. When the conditional persistence of revenue surprises is high (low) relative to its unconditional persistence, both the post‐earnings‐announcement drift and the post‐revenue‐announcement drift are high (low), because investors’ under‐reaction to revenues and earnings is stronger when the persistence of revenue surprises is more strongly associated with the persistence of earnings surprises. Also, the mispricing of accruals decreases substantially when the conditional persistence of accruals is high relative to its unconditional persistence, because investors’ over‐reaction to accruals is mitigated when the persistence of accruals is indeed more strongly associated with the persistence of earnings. Our findings also suggest that financial analysts’ failure to distinguish between unconditional and conditional persistence of revenues and accruals results in more biased revenue and earnings predictions.     

Information Asymmetry and Earnings Management: Some Evidence

This paper conducts an empirical investigation of the relationship between information asymmetry and earnings management predicted by Dye (1988) and Trueman and Titman (1988). When information asymmetry is high, stakeholders do not have sufficient resources, incentives, or access to relevant information to monitor manager's actions, which gives rise to the practice of earnings management (Schipper, 1989; Warfield et al., 1995). Empirical results suggest a systematic relationship between the magnitude of information asymmetry and the level of earnings management in two different settings.     

Return and Volatility Spillovers Between Large and Small Stocks in the UK

Abstract:  This paper investigates return and volatility spillover effects between the FTSE 100, FTSE 250 and FTSE Small Cap equity indices using the multivariate GARCH framework. We find that return and volatility transmission mechanisms between large and small stocks in the UK are asymmetric. In particular, there are significant spillover effects in both returns and volatility from the portfolios of larger stocks to the portfolios of smaller stocks. For volatility, there is also evidence of limited feedback from the portfolios of smaller stocks to the portfolios of larger stocks, although sub-period analysis suggests that this is to some extent period-specific. Simulation evidence shows that non-synchronous trading potentially explains some, but not all, of the spillover effects in returns, and that it explains none of the spillover effects in volatility. These results are consistent with a market in which information is first incorporated into the prices of large stocks before being impounded into the prices of small stocks.