Ebook Transparency, Stock Return Synchronicity, and the Informativeness of Stock Prices: Theory and Evidence
Financial economists generally agree that in efficient markets, stock prices change to reflect available information - either firm-specific or market-wide. Recent literature has addressed the question of how a firm’s information environment (disclosure policy, analyst following) or its institutional environment (property rights protection, quality of government, legal origin) can affect the relative importance of firm-specific as opposed to market wide factors (Jin and Myers (2006), Piotroski and Roulstone (2003), Chan and Hameed (2006), Morck, Yeung and Yu (2000)). This literature has taken the perspective that if the firm’s environment causes stock prices to aggregate more firm-specific information, market factors should explain a smaller proportion of the variation in stock returns. In other words, the stock return synchronicity or R2 from a standard market model regression should be lower.
This perspective, while intuitive, is at odds with another equally intuitive implication of market efficiency. In efficient markets, stock prices respond only to announcements that are not already anticipated by the market. When the information environment surrounding a firm improves and more firm-specific information is available, market participants are also able to improve their predictions about the occurrence of future firm-specific events. As a result, prevailing stock prices are likely to already “factor in” the likelihood of occurrence of these events. When the events actually happen in the future, the market will not react to such news, since there is little “surprise.” In other words, more informative stock prices today should be associated with less firm-specific variation in stock prices in the future. Therefore, the return synchronicity should be higher.
As an example, suppose that there are two sources of uncertainty about a firm. One is related to firm-specific characteristics, e.g., which projects the firm is undertaking, the ability of the manager, etc. The other is due to factors that affect the market return. Now let us consider the extreme case of a company that is “completely transparent.” That is, everything about the firm-specific characteristic is observable and already reflected in the stock price. Then the only uncertainty comes from the market. In a standard market model regression, the market factor explains all variation in the firm’s stock returns; a completely transparent firm should have an R2 of 1! Now compare this completely transparent firm with an opaque firm, for which the market does not have full information. News announcements, such as earnings announcements, would help the market infer managerial and project quality, and the stock price should respond to such announcements. Therefore, the market factor does not fully explain variability in future returns, and the opaque firm will have lower return synchronicity or R2 than the more transparent firm.
In this paper, we present a simple model to illustrate the point that a more transparent information environment can lead to higher, rather than lower, stock return synchronicity. This is because, for a more transparent firm, there is already more information “out there”, reducing the “surprise” from future announcements. In our model, we distinguish between two types of firm specific information. One pertains to time-varying firm characteristics, reflecting the current state of the firm, such as next quarter’s earnings. The other is time-invariant, such as managerial quality. Stock return synchronicity can increase subsequent to an improvement in transparency through disclosure of both types of information. First, greater transparency can lead to early disclosure of time-variant information.
This can happen around major events such as seasoned equity issues (SEOs) or cross-listings, during which a big chunk of information about future events is revealed. Thus when future events actually happen, there is less “surprise” and hence less additional information to be incorporated in the stock price, resulting in a higher return synchronicity. While the positive effect of greater transparency on return synchronicity is most significant in the case of a one-time lumpy disclosure, we show that it also holds in the more general setting with regular, early disclosure of information. In particular, we show that in a dynamic setting, if at the beginning of every period, outsiders get to know (one period ahead of time) some of the information that otherwise would come out at the end of the period, the return synchronicity is actually higher.
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