The association between unexpected earnings and abnormal security returns in the presence of financial leverage*

Abstract. This study extends the growing literature on the deteminants of the variation in the relationship between unexpected earnings and abnormal security returns (the earnings response coefficient). We hypothesize that the firm's default risk as measured by financial leverage would affect the earnings response coefficient. We test this hypothesis by partitioning firms according to (1) the existence of debt in the capital structure (all-equity versus levered firms) and (2) the level of leverage (low-leverage versus high-leverage firms). The results are generally consistent with our hypothesis. Specifically, we find that the earnings response coefficients are larger for all-equity and low-leverage firms vis-à-vis matched-levered and high-leverage firms, even after controlling for the effects of equity beta, persistence, risk premium, and measurement error in unexpected earnings. Our findings are also robust with respect to the choice of earnings measure, either before or after interest charges. Résumé. L'étude s'inscrit dans le prolongement des travaux de plus en plus nombreux portant sur les déterminants de la fluctuation de la relation entre les bénéfices imprévus et les rendements anormaux des titres (le coefficient de réponse des bénéfices). Les auteurs posent l'hypothèse que le risque de non-paiement de l'entreprise, mesuré en termes de levier financier, influe sur le coefficient de réponse des bénéfices. Les auteurs testent cette hypothèse en classant les entreprises selon 1) l'existence ou non de capitaux empruntés dans la structure du capital (entreprises dont les capitaux sont exclusivement des capitaux propres par rapport aux entreprises dont les capitaux sont en partie empruntés) et 2) l'importance du levier financier (entreprises dont le levier financier est faible par rapport aux entreprises dont l'importance du levier financier est élevée). Dans l'ensemble. les résultats confirment l'hypothèse. De façon plus précise, les coefficients de réponse des bénéfices sont plus élevés pour les entreprises dont les capitaux sont exclusivement des capitaux propres et les entreprises dont le levier financier est faible, par rapport aux entreprises, classées selon la taille et le secteur d'activité, dont les capitaux sont davantage constitués de capitaux empruntés et dont le levier financier est élevé, même lorsque sont contrôlées les répercussions du bêta des capitaux propres, de la persistance, de la prime de risque et de l'erreur de mesure des bénéfices imprévus. Les résultats de leur étude résistent également à l'analyse lorsqu'ils font intervenir le choix de la mesure des bénéfices, avant ou après avoir tenu compte des intérêts débiteurs.     

The Potential Secondary Effects of Consumer Legislation: A Conceptual Framework

In recent years, numerous pieces of consumer-oriented legislation have been passed at both the federal and state levels. Although such laws are usually assumed to have a beneficial impact on consumers, situations may occur when either (a) the law fails to accomplish its primary objectives because of poor design and implementation, weak enforcement, and/or illegal action on the part of business firms that allow them to circum vent the law, or (b) the law leads to unforeseen strategy change by business firms that tend to minimize or nullify the expected benefits of the legislation. These unforeseen reactions or secondary effects frequently serve to weaken the law's potential benefit for the consumer. This paper focuses on the secondary effects problem by examining the kinds of strategy changes that business firms might make in response to consumer legislation and the factors affecting these changes. An analytical framework is developed for evaluating the potential costs to the consumer of these secondary effects and comparing these costs with the expected benefits to be derived from consumer protection laws.     

Stealth Acquisitions and Product Market Competition

We examine whether and how firms structure their merger and acquisition deals to avoid antitrust scrutiny. There are approximately 40% more mergers and acquisitions (M&As) than expected just below deal value thresholds that trigger antitrust review. These “stealth acquisitions” tend to involve financial and governance contract terms that afford greater scope for negotiating and assigning lower deal values. We also show that the equity values, gross margins, and product prices of acquiring firms and their competitors increase following such acquisitions. Our results suggest that acquirers manipulate M&As to avoid antitrust scrutiny, thereby benefiting their own shareholders but potentially harming other corporate stakeholders.     

Naïve Buying Diversification and Narrow Framing by Individual Investors

We provide the first tests to distinguish whether individual investors equally balance their overall portfolios (naïve portfolio diversification, NPD) or, in contrast, equally balance the values of same-day purchases of multiple assets (naïve buying diversification, NBD). We find NBD in purchases of multiple stocks, and in mixed purchases of individual stocks and funds. In contrast, there is little evidence of NPD. Evidence suggests that NBD arises due to stock picking behavior and neglect of diversification. These findings suggest that behavioral finance theory should incorporate transaction, as well as portfolio, framing.     

Retail Derivatives and Sentiment: A Sentiment Measure Constructed from Issuances of Retail Structured Equity Products

We use retail structured equity product (SEP) issuances to construct a new sentiment measure for large capitalization stocks. The SEP sentiment measure predicts negative abnormal returns on the SEP reference stocks based on a variety of factor models, and also predicts returns in Fama-MacBeth regressions that include a wide range of covariates. Consistent with our interpretation that SEP issuances reflect investor sentiment, aggregate SEP issuances are highly correlated with the Baker-Wurgler sentiment index. Tobit regressions reveal that proxies for attention and sentiment predict SEP issuance volumes, providing additional evidence consistent with the hypothesis that SEP issuances reflect sentiment.