Exchange trading rules and stock market liquidity

We examine stock exchange trading rules for market manipulation, insider trading, and broker–agency conflict, across countries and over time, in 42 stock exchanges around the world. Some stock exchanges have extremely detailed rules that explicitly prohibit specific manipulative practices, but others use less precise and broadly framed rules. We create new indices for market manipulation, insider trading, and broker–agency conflict based on the specific provisions in the trading rules of each stock exchange. We show that differences in exchange trading rules, over time and across markets, significantly affect liquidity.     

The incremental impact of analyst initiation of coverage

I compare the return surrounding a sell-side analyst's initiation of coverage to the return surrounding a recommendation by an analyst who already covers the stock. The market responds more positively to analysts' initiations than to other recommendations. The incremental price impact of an initiation is 1.02% greater than the reaction to a recommendation by an analyst who already covers the stock. I examine whether the hypothesis that analyst coverage increases liquidity explains this incremental return. I find that liquidity improves after initiations, but that one must extend the liquidity hypothesis in order to fully explain the incremental price impact. Liquidity gains subsequent to analyst initiation depend on the analyst's recommendation. The more positive the initial recommendation, the greater the subsequent liquidity improvement. I also find that the initiation abnormal return correlates with the subsequent improvements in liquidity. Corporations should encourage analyst coverage to capture this liquidity benefit.     

Conflicts of Interest and Research Quality of Affiliated Analysts in the German Universal Banking System: Evidence from IPO Underwriting

The quality of equity research by financial analysts is a prerequisite for an efficient capital market. This study investigates the quality of earnings forecasts and stock recommendations for initial public offerings (IPOs) in Germany. The empirical study includes 12,605 earnings forecasts and 6,209 stock recommendations of individual analysts for the time period from 1997 to 2004. The focus of this study is on analysing the potential conflicts of interest that arise when the analyst is affiliated with the underwriter of an IPO. In a universal banking system these conflicts of interest are usually more pronounced and therefore interesting to investigate. The empirical findings for the German financial market suggest that earnings forecasts and stock recommendations of the analysts belonging to the lead-underwriter are on average inaccurate and biased, indicating some conflicts of interest. Moreover, the stock recommendations of the analysts that are affiliated with the lead-underwriter are often too optimistic resulting in a significant long-run underperformance for the investor. In contrast, unaffiliated analysts provide better earnings forecasts and stock recommendations that result in a superior performance for the investor.     

Are Economically Significant Stock Returns and Trading Volumes Driven by Firm‐specific News Releases?

This paper explores whether firm‐specific information events drive economically relevant positive and negative stock price changes and trading volume and, if so, the nature of such information. We find that no less than 65% of significant price changes and trading volume movements in our sample of FTSE 350 companies can be readily explained by public domain information contradicting the thesis that corporate news is not a primary driver, and that share price changes and trading volume activity are driven by factors unrelated to information flows per se. In addition, we find that a parsimonious set of news categories represent the key drivers. Sell‐side analyst stock recommendations and earnings forecast revisions as a class, unaccompanied by other news releases, dominate all other news categories in terms of significant market reaction. However, taking into account the relative magnitude of market response to different news releases, firms' formal accounting disclosures dominate within this domain. As such, we conclude these are not fully anticipated by apparently more timely market disclosures, and that the existence of news services and the activities of the sell‐side analyst are not substitutes for a firm's interim and preliminary results.     

Chaebol-affiliated analysts: Conflicts of interest and market responses

Some Korean business groups, or chaebols, have a large stake in securities firms that issue analysts’ reports on their member companies. This structure is unique in that industrial companies and securities firms are affiliated and operate within the same group. We investigate the informational content of earnings forecasts, stock recommendations and target prices made by the chaebol-affiliated analysts, using data collected between 2000 and 2008. The chaebol analysts tend to make more optimistic earnings forecasts for the member companies. The mean EPS forecast error (5.36%) of the affiliated analysts for the same chaebol company are significantly larger than that (3.23%) of other chaebol and independent analysts. The chaebol analysts also assign better recommendations by almost one level and set target prices 2.5% higher to the member companies after controlling for company and analyst characteristics. These results are consistent with the hypothesis that chaebol analysts’ reports are biased by conflicts of interest. Stock market reactions do not differ in response to announcements of stock recommendations issued by affiliated vs. non-affiliated analysts. This suggests that capital markets do not recognize the conflicts of interest inherent in chaebol analysts’ reports.     

The Client Is King: Do Mutual Fund Relationships Bias Analyst Recommendations?

This paper investigates whether the business relations between mutual funds and brokerage firms influence sell‐side analyst recommendations. Using a unique data set that discloses brokerage firms’ commission income derived from each mutual fund client as well as the share holdings of these mutual funds, we find that an analyst's recommendation on a stock relative to consensus is significantly higher if the stock is held by the mutual fund clients of the analyst's brokerage firm. The optimism in analyst recommendations increases with the weight of the stock in a mutual fund client's portfolio and the commission revenue generated from the mutual fund client. However, this favorable recommendation bias toward a client's existing portfolio stocks is mitigated if the stock in question is highly visible to other mutual fund investors. Abnormal stock returns are significantly greater both for the announcement period and, in the long run, for favorable stock recommendations from analysts not subject to client pressure than for equally favorable recommendations from business‐related analysts. In addition, we find that, subsequent to announcements of bad news from the covered firms, analysts are significantly less likely to downgrade a stock held by client mutual funds. Mutual funds increase their holdings in a stock that receives a favorable recommendation but this impact is significantly reduced if the recommendation comes from analysts subject to client pressure.     

Getting Out Early: An Analysis of Market Making Activity at the Recommending Analyst's Firm

This paper examines trading volume for Nasdaq market makers around analyst recommendation changes issued by an analyst at the same firm. Using Nasdaq PostData, we find a disproportionate increase in market making volume associated with the firm's recommendation changes and evidence of elevated sell volume at the recommending analyst's firm in the 2 days preceding a downgrade. The implications are that the information source matters in determining the placement of trades and that the issuing analyst's firm appears to be rewarded for prereleasing information through increased volume. These findings constitute new evidence of compensation for research production through the market making channel.     

Sell‐Side Analyst Research and Stock Comovement

We document that a stock's price around a recommendation or forecast covaries with prices of other stocks the issuing analyst covers. The effect of shared analyst coverage on stock price comovement extends beyond analyst activity days. A stock's daily returns covary with the returns of other stocks with which it shares analyst coverage. These links between stock price comovement and shared analyst coverage are consistent with the coverage‐specific information we find in earnings forecasts; analysts who cover both stocks in a pair expect future earnings of the stocks to be more highly correlated than do analysts who cover only one stock from the pair. Collectively, our evidence indicates that analyst research produces coverage‐specific spillovers that raise price comovement among stocks that share analyst coverage. The strength of these spillovers is comparable to spillovers from broad industry and market information in analyst research.     

Affiliated mutual funds and analyst optimism

This paper extends the literature on analyst optimism. Our analysis of a large sample of recommendations issued from 1995 through 2006 indicates that sell-side analysts are likely to assign frequent and favorable ratings to a stock after the analysts’ affiliated mutual funds invest in that stock. Controlling for a number of variables, including the ties between analysts and investment banks, we find that the greater the portfolio weight of a stock in the fund family, the more optimistic the stock ratings from affiliated analysts become. Since 2002, analysts’ optimism on stocks held by affiliated mutual funds has declined. However, an analyst's decision of upgrading a stock to a “strong buy” rating is still significantly associated with the portfolio weight of that stock in the fund family.     

Regulation fair disclosure and the market’s reaction to analyst investment recommendation changes

Previous research has shown that affiliated analysts (those who are working for investment banks that underwrite securities for companies) have an incentive to provide optimistically biased recommendations from selective information they are given by the firm. In an effort to halt such activities, as of October 2000, Regulation Fair Disclosure (RegFD) prohibits selective disclosure of material non-public information by public companies to privileged individuals (such as favored research analysts) and requires broad, non-exclusionary disclosure of such information. We examine firms’ stock price reactions to investment recommendation changes from affiliated analysts versus unaffiliated analysts from October 1998 to November 2002, around the passage of RegFD. Similar to previous research, we find that investors reacted more significantly to recommendation downgrades by affiliated analysts than to those by unaffiliated analysts prior to the passage of RegFD. However, we find that the difference in the reactions to recommendation changes is not present after the passage of RegFD. We also find that stock price reactions to analysts’ (both affiliated and unaffiliated) recommendation changes decreased significantly after the passage of RegFD. Thus, RegFD appears to have curbed the selective disclosure of information (particularly negative information) by firms to affiliated analysts. Further, the smaller reactions to recommendation changes by all analysts after RegFD may reflect a change in analysts’ behavior (irrespective of information that is available) or a response by corporate managers to withhold information rather than risking a violation of fair disclosure rules.     

Rewriting History

We document widespread changes to the historical I/B/E/S analyst stock recommendations database. Across seven I/B/E/S downloads, obtained between 2000 and 2007, we find that between 6,580 (1.6%) and 97,582 (21.7%) of matched observations are different from one download to the next. The changes include alterations of recommendations, additions and deletions of records, and removal of analyst names. These changes are nonrandom, clustering by analyst reputation, broker size and status, and recommendation boldness, and affect trading signal classifications and back-tests of three stylized facts: profitability of trading signals, profitability of consensus recommendation changes, and persistence in individual analyst stock-picking ability.     

The outperformance of family firms: the role of variance in earnings per share and analyst forecast dispersion on the Swiss market

Recent studies provide empirical evidence that family firms are outperforming their non-family counterparts in terms of stock market performance. For the Swiss stock market we find that family firms indeed outperform their non-family counterparts after controlling for firm size and beta. In addition, our data shows that family firms display more stable earnings per share in contrast to their non-family counterparts. Furthermore we find that the variance of earnings per share positively affects analyst forecast dispersion. According to anomaly literature, lower analyst forecast dispersion has been found to induce higher excess return, which our data supports for the Swiss stock market. By linking variance of earnings per share, analyst forecast dispersion and stock performance we provide an insightful explanation for the excess stock market returns of family firms. In addition, our text extends the theory of dispersion effect with an additional empirical element, the variance of earnings per share.      

The effect of affiliated analysts on stock recommendations: Evidence from share pledges in China

We use the share pledge context in China to examine how affiliated analysts whose securities companies are pledgees of share pledge firms issue stock recommendations on these listed firms. We find that their recommendations are more optimistic than those of non-affiliated analysts, and they are more likely to issue Buy and Add recommendations, suggesting that they issue optimistic rating reports for share pledge firms due to their conflicts of interest. We also find a dynamic adjustment in the stock recommendation behavior of these analysts, and their probability after issuing optimistic stock recommendations is significantly reduced before and after the years that the affiliation relationship between them and share pledge firms both began and ended. These affiliated analysts continue to issue optimistic stock recommendations after visiting the share pledge firms if they work in the same location as the firms, or if they are star analysts among New Fortune’s “top five analysts,” and when the information transparency of the share pledge firms is higher. In addition, the optimistic stock recommendation behavior of affiliated analysts is more significant in our sample of firms with high share pledge ratios and downward stock price pressure. The earnings forecast quality of affiliated analysts is also found to be lower, and they are less inclined to downgrade stock recommendations for these share pledge firms. Buy recommendations issued by both non-affiliated and affiliated analysts can bring cumulative excess returns in the short event window, but those issued by affiliated analysts are significantly negative in the long-term event window, and significantly lower than those issued by non-affiliated analysts. Overall, our study shows that affiliated analysts issue optimistic rating reports on share pledge firms due to conflicts of interest, which leads to decision-making bias in investors and thus decreases the stock price crash risk of the firms. Our findings further reveal the economic consequences of share pledging and extend our understanding of the behavior of analysts in a conflict of interest situation from the share pledge perspective.     

Are small investors naive about incentives?

Security analysts tend to bias stock recommendations upward, particularly if they are affiliated with the underwriter. We analyze how investors account for such distortions. Using the NYSE Trades and Quotations database, we find that large traders adjust their trading response downward. While they exert buy pressure following strong buy recommendations, they display no reaction to buy recommendations and selling pressure following hold recommendations. This “discounting” is even more pronounced when the analyst is affiliated with the underwriter. Small traders, instead, follow recommendations literally. They exert positive pressure following both buy and strong buy recommendations and zero pressure following hold recommendations. We discuss possible explanations for the differences in trading response, including information costs and investor naiveté.     

Behavioural Bias and Conflicts of Interest in Analyst Stock Recommendations

Abstract:  This paper tests whether sell-side analysts are prone to behavioural errors when making stock recommendations as well as the impact of investment banking relationships on their judgments. In particular, we analyse their report narratives for evidence of cognitive bias. We find first that new buy recommendations on average have no investment value whereas new sell recommendations do, and take time to be assimilated by the market. We also show that new buy recommendations are distinguished from new sells both by the level of analyst optimism and representativeness bias as well as with increased conflicts of interest. Successful new buy recommendations are characterised by lower prior returns, value stock status, smaller firms and weaker investment banking relationships. On the other hand, successful new sells do not differ from their unsuccessful counterparts in terms of these measures. As such, we provide evidence that analysts are prone both to behavioural bias as well as potential conflicts of interest in their new buy stock recommendation decisions. We also show that these two explanations of analyst behaviour are to a great extent independent of each other. Consequently, the recent attempts by regulators to address potential conflicts of interest in analyst behaviour may have only limited impact.     

THE SPEED OF ADJUSTMENT OF PRICES TO PRIVATE INFORMATION: EMPIRICAL TESTS

We estimate speeds of adjustment of individual stock prices to private information using daily data. We use a model in which private information gives rise to return variance and private information decays linearly over time. We find that, on average, about 85 percent to 88 percent of private information is incorporated into prices within one trading day, with variation depending upon the stock's trading volume and whether the stock is listed on an exchange. The findings support strong form market efficiency.     

ANALYST REPUTATION,DEALER AFFILIATION,AND MARKET MAKING

We investigate the effects of analysts' affiliation and reputation on dealers' market making activities. We find that for a given stock, dealers who have affiliated analysts covering the stock quote and trade more aggressively than those who do not have any affiliated analysts. More important, the reputation of affiliated analysts plays an additional role in the affiliated dealer's quote and trade behavior. Dealers with affiliated star analysts post more aggressive quotes and have larger market shares than dealers with affiliated nonstar analysts. Although dealers who post more aggressive quotes also induce affiliated star analysts to cover the stocks, the positive effect of analyst reputation on the affiliated dealers' quote aggressiveness remains significant and robust after controlling for potential endogenous and simultaneous problems.     

To buy or not to buy? The value of contradictory analyst signals

We study the predictive ability of individual analyst target price changes for post-event abnormal stock returns within each recommendation category. Although prior studies generally demonstrate the investment value of target prices, we find that target price changes do not cause abnormal returns within each recommendation level. Instead, contradictory analyst signals (e.g., strong buy reiterations with large target price decreases) neutralize each other, whereas confirmatory signals reinforce each other. Further, our analysis reveals that large target price downgrades can be explained by preceding stock price decreases. However, upgrades are not preceded by stock price increases, thereby demonstrating asymmetric analyst behavior when adjusting target prices to stock prices. Our results suggest that investors should treat recommendations with caution when they are issued with large contradictory target price changes. Thus, instead of blindly following a recommendation, investors might put more weight on the change in the corresponding target price and consider transaction costs.     

Reading between the lines: An empirical examination of qualitative attributes of financial analysts’ reports

This paper examines whether two qualitative attributes of financial analysts’ reports, detail and tone, are significant in explaining how the market responds to analysts’ reports, after controlling for the information contained in the reports’ quantitative summary measures. Report detail is hypothesized to reflect the level of effort expended by the analyst in preparing the report, and therefore the usefulness of their intrinsic firm value estimates. Report tone is predicted to signal the analyst’s underlying sentiment regarding the firm and may be used to assess the extent to which analysts’ conflicts of interest interfere with the mapping of firm value estimates into stock recommendations. Consistent with these hypotheses, we find that the tone of financial analyst reports contain significant information content incremental to the reports’ earnings forecasts and recommendations, and report complexity (one component of report detail) helps explain cross-sectional variation in the market’s response to the reports’ recommendations.     

Do independent research analysts issue more or less informative recommendation revisions?

This paper studies whether independent research analysts issue more informative stock recommendation revisions than investment bank analysts. I find independent analyst recommendation upgrades and downgrades significantly less informative. I also investigate whether the identified differences in informativeness are the result of systematic cross-sectional variation in analyst ability, portfolio complexity, and brokerage firm resources. Including these variables reduces the disparity in information content between groups. However, independent revisions continue to have lower informativeness. I follow prior research and compute daily buy-and-hold abnormal returns to portfolios formed based on analyst firm type. I find that investment bank analyst portfolios generally outperform those of independent research analysts. Lastly, I examine market reactions before and after the Global Settlement Agreement that was enacted to limit the perceived conflicts in the industry. Lastly, investment bank analyst upgrades generate an 18.7% greater reaction in the post-regulation period, suggesting the Global Settlement helped mitigate biased research. Independent analysts continue to issue less informative recommendations.