Newswise — Executives versed in the trading industry already know that private information gathered and revealed before an earnings announcement and public information revealed at the time of the announcement results in increased trading.
But new empirical evidence from David Harris, associate professor of accounting in the Whitman School of Management at Syracuse University, adds a third piece to this equation. Harris finds that private information held by traders yet unrevealed publicly at the time of earnings announcement (known as private event-period information) also results in greater trading volume.
"Private event-period information is new information that arises as a result of interaction between the public announcement and private information that is useful in conjunction with the announcement," says Harris.
In fact, Harris finds that the public earnings announcement can lead to the circulation of more private information which reduces consensus about firms' value and therefore spurs investor trading.
These findings, presented in "Evidence That Investors Trade on Private Event-Period Information around Earnings Announcements" and published in The Accounting Review, have significant implications for firm managers and accounting policymakers who seek to level the trading playing field.
"If a significant amount of trade on private information occurs when public disclosure peaks, unsophisticated traders have a greater disadvantage," says Harris. "Investors tend to trade based on their own interpretation of private event-period information. Traders who lack this type of information therefore seem to be less productive than their counterparts who have access to this information."
To offset the disadvantage, firms' managers and accounting policymakers should consider that the unevenness of the informational playing field can be reduced by the quality and quantity of information they provide. This might be especially important for information released before an earnings announcement, thereby reducing both the surprise and the value of privately collected information. Encouraging firms to be both more forthcoming and prompt in releasing relevant information will reduce an uneven trading field.
Harris's findings indicate that this uneven informational playing field among traders can increase firms' cost of capital. "Earnings announcements typically trigger a great release of the private information of analysts," says Harris. "When traders begin trading based on this type of information from analysts, their actions adversely affect firms' cost of capital."
The result is that private information triggered by earnings announcements is a factor in determining costs of capital. These findings are significant to firms and policymakers because it suggests that markets will be more efficient and firms will face lower costs of capital if information is more generally available to the public. Thus, it is in firms' best interests to provide accurate, relevant information on a timely basis.
"Evidence That Investors Trade on Private Event-Period Information around Earnings Announcements" was co-written with Orie E. Barron, associate professor of accounting in the Smeal College of Business at Pennsylvania State University, and Mary Stanford, professor of accounting in the Neely School of Business at Texas Christian University. The paper analyzed data provided by I/B/E/S International Inc through the Institutional Brokers' Estimate System.
The research shows one of the consequences of the uneven distribution of private information and the resulting increase in trading volume, which indirectly suggests that firms' costs of capital are also affected. In future research, Harris plans to examine how this information changes firms' costs of capital by directly measuring costs of capital before and after earnings announcements.
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