Determinants and economic consequences of cash flow restatements

The FASB, PCAOB, SEC, and AICPA have all acknowledged that the accounting field needs to revisit the statement of cash flows (SCF). While the overall number of restatements has held steady over the past five years, the percentage of cash flow restatements (CFRs) has risen from 8.7% of all restatements in 2009 to 20.2% of all restatements in 2014. We examine the determinants of CFRs, investors’ differential beliefs about CFRs, and the information content of CFRs by focusing on abnormal trading volume and price reactions to CFRs. We then examine whether the guidance the SEC/AICPA published in early 2006 changed the information content of CFRs. Finally, since the proper classification within the SCF is a current regulatory issue, we examine whether classification shifting within the SCFs impacts the market. The market finds CFRs to be informative with some investor disagreement as shown by higher abnormal trading volume. We also find an incremental volume reaction to changes in operating cash flows after the SEC allowance period. While the market responds negatively to CFRs, we find that the market does not differentiate between whether classification shifting occurs or does not occur with the CFR. This study has implications for policymakers, auditors, and investors since it is one of the first to examine the capital market consequences of CFRs.     

The Effect of Market Structure on the Incentives to Quote Aggressively: An Empirical Study of Nasdaq Market Makers

We use data on Nasdaq stocks to study arguments that preferencing reduces incentives to quote competitively. We examine a market maker's volume as a function of various measures of quoting aggressiveness. We find that more aggressive quoting does indeed result in more business. We also examine the relation between volume and quote aggressiveness as a function of the competitiveness. We find that in less (more) competitive markets, increased quote aggressiveness has a smaller (larger) impact on market share. We argue that preferencing arrangements could be more harmful to public investors in markets where competition is weak.     

The price of liquidity: CD rates charged by money market funds

We examine the cost of liquidity in rates on CDs purchased by money market funds (MMFs). We find no evidence that rates vary directly with the size of CDs. However, we do find that large MMFs receive higher rates on large CDs than small MMFs. This suggests banks pay for (potential) liquidity.     

Disagreement and asset prices

How do differences of opinion affect asset prices? Do investors earn a risk premium when disagreement arises in the market? Despite their fundamental importance, these questions are among the most controversial issues in finance. In this paper, we use a novel data set that allows us to directly measure the level of disagreement among Wall Street mortgage dealers about prepayment speeds. We examine how disagreement evolves over time and study its effects on expected returns, return volatility, and trading volume in the mortgage-backed security market. We find that increased disagreement is associated with higher expected returns, higher return volatility, and larger trading volume. These results imply that there is a positive risk premium for disagreement in asset prices. We also show that volatility in and of itself does not lead to higher trading volume. Instead, only when disagreement arises in the market is higher uncertainty associated with more trading. Finally, we are able to distinguish empirically between two competing hypotheses regarding how information in markets gets incorporated into asset prices. We find that sophisticated investors appear to update their beliefs through a rational expectations mechanism when disagreement arises.     

Can order exposure be mandated?

In this paper, we examine whether the hidden portion of limit orders represents depth that would be revealed if traders were not allowed to hide it, and the associated market quality implications. Specifically, we examine the decisions by the Toronto Stock Exchange to first abolish the use of hidden limit orders in 1996, and then reintroduce them in 2002. We find that quoted depth does not change following either decision, suggesting that the hidden portion of orders represents depth that would otherwise not be exposed. Using confidential order data for the period following the reintroduction of hidden limit orders, we find that total inside depth increases. For both events, volume does not change and the usage of the limit order book increases if hidden limit orders are allowed. This suggests that if traders are required to expose their orders they will not exit the market, but instead will switch to using market orders. We also find evidence to suggest that informed traders use hidden limit orders to minimize price impact if the probability of non-execution is small.     

An Analysis of Transactions Data for the Stock Exchange of Singapore: Patterns, Absolute Price Change, Trade Size and Number of Transactions

The availability of the transactions data of the Stock Exchange of Singapore allows us to examine intraday patterns and the relation among absolute price change, trade size and number of transactions. The presence of a trading halt in the mid-day results in two crude U-shaped return patterns but, contrary to Brock and Kleidon's (1992) model, it does not cause volume to be unusually high right before or after the halt. We find a positive relationship between absolute price changes and the number of transactions for both the active and inactive stocks. This supports the findings of Jones, Kaul and Lipson (1994) that these relationships also hold at the intraday level and in a market with different market architecture.     

LONG-RUN RELATIONS IN EXCHANGE MARKETS: A TEST OF COVERED INTEREST PARITY

We examine long-run relations implied by covered interest parity (CIP) in possibly cointegrated and nonstationary data series. Empirical evidence suggests that, ignoring market imperfections, CIP failed over January 6, 1984, through December 6, 1991, using weekly data from four major currencies relative to the U.S. dollar. The multivariate maximum likelihood vector autoregressive (VAR) methodology does not require data differencing and hence retains valuable information lost in previous research examining international market flows. Rejections are robust to both subperiod analysis and alternative interest rate series. Although test rejections are highly statistically significant, attainable economic profits appear small. Practitioners will find economic profits inconsequential relative to reasonable bounds on market frictions such as transaction costs. Nonetheless, the use of CIP to determine forward rates identically from interest rates and spot rates in academic studies is called into question.     

THE EFFECT OF CROSS‐LISTING ON TRADING VOLUME: REDUCING SEGMENTATION VERSUS SIGNALING INVESTOR PROTECTION

We examine the relation between cross‐listing on the U.S. and UK regulated and unregulated exchanges and trading volume for a sample of 500 foreign firms from 34 countries. We find that the increase in trading volume is a function of both reducing segmentation and signaling investor protection. In addition, we find that home market trading volume, firm size, firm returns, and analyst forecast accuracy are the major determinants of a firm's trading volume. We also show that U.S. and UK investors trade foreign securities that originate from low‐investor‐protection countries more than they trade those from high‐investor‐protection countries, which is consistent with the bonding hypothesis.     

VPIN,liquidity, and return volatility in the U.S. equity markets

We examine the volume-synchronized probability of informed trading metric (the VPIN flow toxicity metric, developed by Easley, Lopez de Prado, & O'Hara, 2012) as a real-time risk management tool for liquidity deteriorations in the U.S. equity markets. We find that VPIN provides information about market liquidity and stock return volatility on ex-ante basis. These results indicate that VPIN can be a useful risk-management tool for market makers, regulators and traders in the U.S. equity markets. We also document that VPIN is negatively associated with volume and number of trades, but positively associated with trade size and volume fragmentation. These findings suggest that VPIN indicates the adverse selection problem of liquidity providers by capturing the information in volume.     

The Making of a Dealer Market: From Entry to Equilibrium in the Trading of Nasdaq Stocks

This paper provides an analysis of the nature and evolution of a dealer market for Nasdaq stocks. Despite size differences in sample stocks, there is a surprising consistency to their trading. One dealer tends to dominate trading in a stock. Markets are concentrated and spreads are increasing in the volume and market share of the dominant dealer. Entry and exit are ubiquitous. Exiting dealers are those with very low profits and trading volume. Entering market makers fail to capture a meaningful share of trading or profits. Thus, free entry does little to improve the competitive nature of the market as entering dealers have little impact. We find, however, that for small stocks, the Nasdaq dealer market is being more competitive than the specialist market.     

Trading volume and short-horizon contrarian profits: Evidence from the Malaysian market

We provide evidence on short-term predictability of stock returns on the Malaysian stock market. We examine the relation between return predictability and the level of trading activity. This is particularly relevant in emerging stock markets, where thin trading is more pervasive. We find that the returns from a contrarian portfolio strategy are positively related to the level of trading activity in the securities. Specifically, the contrarian profits on actively and frequently traded securities are significantly higher than that generated from the low trading activity securities. We find that the differential behavior of high- and low-volume securities is not subsumed by the size effect, although for the small firms, the volume–predictability relation is most pronounced. We also suggest that the price patterns may be related to the institutional arrangement in the Malaysian stock market.     

Internal control reporting and market liquidity

We investigate the impact of the Sarbanes-Oxley Act of 2002 (SOX) on information asymmetry by analyzing the relation between SOX Sections 302 and 404 control reports and market liquidity using bid-ask spreads. Lower market liquidity indicates higher levels of information asymmetry implying that market participants perceive financial statement misstatement risk is higher. If SOX disclosures contain relevant information, then one would expect firms reporting internal control material weaknesses to have lower market liquidity. Accordingly, we find that market liquidity is lower (i.e., bid-ask spreads are higher) for firms reporting ineffective control compared to firms reporting effective control using either annual SOX 404 internal control reports or quarterly SOX 302 disclosure control reports, which suggests that SOX 302 and 404 reports provide useful information for identifying firms with a higher risk of financial statement misstatement. However, we do not find consistent results using two alternative liquidity measures: trading volume and market quality indices. We then examine whether changes in control reports are associated with changes in market liquidity. We generally do not find that firms with improved (deteriorated) control reports experience a larger decrease (increase) in bid-ask spreads or larger increases (decreases) in trading volume and market quality indices compared to other firms, suggesting that market participants do not discern a change in information asymmetry when the effectiveness of internal controls over financial reporting changes.     

Using Expectations to Test Asset Pricing Models

Asset pricing models generate predictions relating assets' expected rates of return and their risk attributes. Most tests of these models have employed realized rates of return as a proxy for expected return. We use analysts' expected rates of return to examine the relation between these expectations and firm attributes. By assuming that analysts' expectations are unbiased estimates of market-wide expected rates of return, we can circumvent the use of realized rates of return and provide evidence on the predictions emanating from traditional asset pricing models. We find a positive, robust relation between expected return and market beta and a negative relation between expected return and firm size, consistent with the notion that these are risk factors. We do not find that high book-to-market firms are expected to earn higher returns than low book-to-market firms, inconsistent with the notion that book-to-market is a risk factor.     

Effect of the Actual Size Rule Under Market Stress

We examine the introduction of the Actual Size Rule (ASR) on Nasdaq during a control period and a period of market stress. We find that market makers in both ASR and Non-ASR stocks reduce quotation sizes and widen spreads when under stress but the reduction of quotation size and increase in spread width are significantly larger for ASR stocks. We also examine October 27, when the market was under the most severe stress. We find ASR and Non-ASR stocks have similar reductions in time-weighted quotation ask size when compared with the control sample but ASR bid sizes are about 10% smaller than Non-ASR bid sizes. Our findings imply that the ASR rule may significantly reduce market quality under times of market stress. JEL Classification: 14, G15, G18     

The size effect in the Mexican stock market

This paper tests for a firm size effect in the Mexican stock market using data from January 1987 to December 1992. Our initial tests indicate that average stock returns are positively related to market betas. We also find, however, that average returns are negatively related to firm size. To measure the effects on average return of betas that are unrelated to firm size, we examine portfolios formed on the basis of size and beta We find that beta is priced in addition to firm size for the Mexican stock market, even after carefully separating the effects of beta and size.     

Information asymmetry and accounting restatement: NYSE-AMEX and NASDAQ evidence

We examine the impact of accounting restatement announcement on firms’ value and information asymmetry for both auction market (NYSE-AMEX) and dealer market (NASDAQ) using a public sample of restatement announcements from 1997 to 2005. In both markets, we document economically and significantly negative mean cumulative abnormal returns around the announcement dates. The restatements attributed to auditors are associated with more negative returns than those attributed to management and the SEC. However, there is no significant difference between market reactions arising from the core and non-core restatements. We also find a significant increase in volume, number of transactions, average order size, volatility, and various measures of spreads after the restatement announcement indicating that restatement announcements diminish company prospects and contribute to increased uncertainty and information asymmetry. Finally, we find that the information asymmetry in the NASDAQ market around the event date is less pronounced than in the NYSE-AMEX market.     

Monitoring and Controlling Bank Risk: Does Risky Debt Help?

We examine whether mandating banks to issue subordinated debt would enhance market monitoring and control risk taking. To evaluate whether subordinated debt enhances risk monitoring, we extract the credit‐spread curve for each banking firm in our sample and examine whether changes in credit spreads reflect changes in bank risk variables, after controlling for changes in market and liquidity variables. We do not find strong and consistent evidence that they do. To evaluate whether subordinated debt controls risk taking, we examine whether the first issue of subordinated debt changes the risk‐taking behavior of a bank. We find that it does not.     

Chinese IPO activity,pricing, and market cycles

We examine the activity, pricing, and market cycles of 1,380 Chinese A share IPOs over the period 1991–2005 and find initial underpricing of 238%. The government restrictions on IPO offer price and quota allocation cause pricing structural breaks and attribute more than half of initial underpricing. A multifactor model that includes firm’s characteristics, excess demand for IPO shares, and the government restrictions explains cross-sectional initial returns, after controlling for industrial differences and stock market conditions. In addition, monthly IPO volume and average initial return are highly correlated. A VAR model indicates that initial return leads IPO volume by 6 months.     

Trading activity and price reversals in futures markets

We use the standard contrarian portfolio approach to examine short-horizon return predictability in 24 US futures markets. We find strong evidence of weekly return reversals, similar to the findings from equity market studies. When interacting between past returns and lagged changes in trading activity (volume and/or open interest), we find that the profits to contrarian portfolio strategies are, on average, positively associated with lagged changes in trading volume, but negatively related to lagged changes in open interest. We also show that futures return predictability is more pronounced if interacting between past returns and lagged changes in both volume and open interest. Our results suggest that futures market overreaction exists, and both past prices and trading activity contain useful information about future market movements. These findings have implications for futures market efficiency and are useful for futures market participants, particularly commodity pool operators.     

A Cross-Sectional Empirical Test of a Dual-State Multi-Factor Pricing Model

During empirical testing of the Capital Asset Pricing Model an assumption is typically made that risk is intertemporally constant. However, prior research finds that risk changes over time. We empirically test a conditional dual-state cross-sectional model allowing risk to change through prior identification of different market and economic states. We examine relationships between returns and conditional market and economic-factor betas, size, book-to-market equity, and earnings-price ratios. We find that relationships shift across regimes, suggesting the importance of a conditional, as opposed to unconditional, model. Relationships also change in January.