Access

You are not currently logged in.

Access your personal account or get JSTOR access through your library or other institution:

login

Log in to your personal account or through your institution.

Security Returns around Earnings Announcements

Ray Ball and S. P. Kothari
The Accounting Review
Vol. 66, No. 4 (Oct., 1991), pp. 718-738
Stable URL: http://www.jstor.org/stable/248152
Page Count: 21
  • Subscribe ($19.50)
  • Cite this Item
Security Returns around Earnings Announcements
Preview not available

Abstract

We examine risk, return, and abnormal return behavior in the days around quarterly earnings announcements, using a research design that allows risk to vary daily in event time. We test several hypotheses concerning the effect on security prices of earnings announcements per se (i.e., ignoring both the sign and the magnitude of earnings). The first hypothesis concerns the resolution of uncertainty over time. By conveying information about firms' activities, earnings announcements resolve some uncertainty about future cash flows, but the concurrent price reactions increase the variability and covariability of securities' returns during the announcements. Thus, it is hypothesized that return variances and betas, and therefore expected returns, increase during earnings announcement periods (Stapleton and Subrahmanyam 1979; Epstein and Turnbull 1980; Choi and Salamon 1989). Previous research has demonstrated anomalous positive abnormal returns during earnings announcements (Chambers and Penman 1984; Penman 1984, 1987; Chari et al. 1988). Because risk was not allowed to vary in event time in this research, it does not adequately distinguish between increased expected returns and true abnormal returns. We report that abnormal returns remain after controlling for risk increases at earnings announcements. The abnormal returns are not related to any over- or under-reaction by the market to earnings news (see, e.g., DeBondt and Thaler 1985, 1987; Bernard and Thomas 1989) because we do not condition on the earnings realization. The second hypothesis (the information hypothesis) is that the timing of an earnings announcement is informative because managers systematically announce good news early and bad news late (Givoly and Palmon 1982; Chambers and Penman 1984; Kross and Schroeder 1984). The hypothesis predicts that average abnornal returns: (1) are positive at the earnings announcement, (2) are negative prior to the announcement, and (3) cumulate to zero by the end of the announcement period. Our tests extend those of Chari et al. (1988), Kross and Schroeder (1984) and Chambers and Penman (1984) by examining the pattern of returns around earnings announcements for the population of stocks. The pattern we observe is not as predicted by the information hypothesis. Finally, we investigate whether cross-sectional variation in announcement-period risks and returns is a function of firm size, which is a proxy for the increase in information arrival during earnings announcement periods. The evidence reveals that, after controlling for risk increases, abnormal returns generally are positive and decreasing in firm size. For the smallest size decile, abnormal returns in the ten days up to and including the earnings announcement are approximately 1.75 percent in the average quarter, or approximately 7 percent over only 40 trading days per year. This adds to an impressive body of size-related anomalies. We use these results to reexamine Hand's (1990) reinterpretation of the functional fixation hypothesis. Hand investigated quarterly earnings that included previously announced book gains from debt-equity swaps. He distinguished between "sophisticated" and "unsophisticated" investors, hypothesizing that only the former correctly comprehend the different implications of swap gains and other components of earnings. He found that abnormal returns increase in a variable representing the interaction between the swap gain and a proxy for the probability that the marginal investor is unsophisticated. We are skeptical about both the hypothesis and whether it predicts the observed result. We interpret Hand's result as similar to the puzzling but typical size effect around earnings announcements. It seems unlikely to be due to swap gains, to the sign or magnitude of earnings information released at the time, to errors in measuring the earnings information released, or to functional fixation.

Page Thumbnails

  • Thumbnail: Page 
718
    718
  • Thumbnail: Page 
719
    719
  • Thumbnail: Page 
720
    720
  • Thumbnail: Page 
721
    721
  • Thumbnail: Page 
722
    722
  • Thumbnail: Page 
723
    723
  • Thumbnail: Page 
724
    724
  • Thumbnail: Page 
725
    725
  • Thumbnail: Page 
726
    726
  • Thumbnail: Page 
727
    727
  • Thumbnail: Page 
728
    728
  • Thumbnail: Page 
729
    729
  • Thumbnail: Page 
730
    730
  • Thumbnail: Page 
731
    731
  • Thumbnail: Page 
732
    732
  • Thumbnail: Page 
733
    733
  • Thumbnail: Page 
734
    734
  • Thumbnail: Page 
735
    735
  • Thumbnail: Page 
736
    736
  • Thumbnail: Page 
737
    737
  • Thumbnail: Page 
738
    738