Are Markets Rational? Investors’ Response to Persistent Bias in Analysts’ Earnings Forecasts

This dissertation intends to address the following two issues: 1) Persistence of the bias in analysts\u27 earnings forecasts; 2) Investors’ response to such bias. It extends the understanding of information economics in earnings studies, and is expected to improve asset pricing models, suggest better model specifications for earnings studies, provide regulatory policy implications, and facilitate discussions on investor rationality. Using two look-back portfolio formation methods that capture salient features of analysts\u27 past forecasting behavior, I form quintile portfolios that describe the range of analysts\u27 forecasting behavior. The optimistic portfolios refer to the portfolios containing firm-quarters whose contemporaneous forecast errors are likely to be negative, while the pessimistic portfolios refer to the portfolios containing firm-quarters whose contemporaneous forecast errors are likely to be positive. Evidence that the two formation methods have significant predictive power for the contemporaneous forecast errors is found and this suggests that there is persistent bias in analysts’ earnings forecasts. Investors’ response to the persistent bias is characterized by two hypotheses. The naïve expectations hypothesis (NEH) predicts that investors naively follow analysts’ past forecasting behavior, while the rational expectations hypothesis (REH) predicts that investors fully adjust for analysts’ past forecasting behavior when investors form their own expectations about contemporaneous earnings. Major findings are reported regarding behaviors of two market participants − financial analysts and investors − in forming their expectations in quarterly earnings. The first set of findings provides strong evidence of persistent bias in analysts\u27 forecasts. The second set of findings suggests that investors’ reaction to analysts’ forecasting behavior is complex. The data does not strongly reject the NEH in favor of the REH. It is speculated that investors sometimes seem neither naïve nor rational. Rather, they seem to possess another type of quasi-rational behavior other than naïve. As a result, the simple framework (NEH versus REH) used in this dissertation has a limit. The examination of a full range of investor behavior is encouraged for future research

Shareholder Protection And Forecast Bias

This research explores whether shareholder protection influences analyst optimism and forecast accuracy in a global setting. The first set of empirical results suggests that, as commonly observed in the existing domestic literature, analyst optimism characterizes analysts’ forecasts in the 19 sample countries. Further empirical results provide evidence that analyst forecasts issued in countries with strong shareholder protection laws are less optimistic and more accurate than analyst forecasts published in countries with weak protection laws. It is also observed that analyst forecast is superior to a naïve model of no change in earnings. (JEL: G15, G18

Agency Conflicts, Financial Distress, and Syndicate Structure: Evidence from Japanese Borrowers

We examine how borrower firm characteristics affect the size structure in the Japanese syndicated loan market for the 1999-2003 period. Consistent with the view by Lee and Mullineaux (2004), we find that syndicates are smaller when borrowers have higher credit risk, while firms with greater information asymmetry are associated with larger syndicates in Japan. These results are primarily driven by nonkeiretsu (non-business group) firms. This suggests that the role of enhanced monitoring and facilitated renegotiation is especially useful for banks participating in Japanese syndicated loan for non-keiretsu firms. On the other hand, information problems seem to be less severe for keiretsu (business group) firms which tend to have easier access to syndicated loan via the intermediation of in-house banks in the relevant syndicate. Finally, we find that keiretsu (non-keiretsu) firms have less (more) fraction of loan by their agent banks as the maturity rises. It appears that main banks of keiretsu firms with informational advantage are likely to retain less of the loan and form a more dispersed syndicate to "signal' that the loan is of high quality with increased maturity. This further confirms the view that information problems are less severe in the keiretsu firms.

Investor reaction to earnings management

Purpose – The purpose of this paper is to investigate whether earnings management that surpasses a threshold is associated with market mispricing. Design/methodology/approach – The paper examines the level of discretionary current accruals (DCA) as a proxy for earnings quality. Operationally the threshold of earnings management is defined as the mean DCA, and it is assumed that highly managed firms (both income-decreasing and income-increasing) produce low-quality earnings information. It is postulated that such management may lead to mispricing errors by investors who make incorrect adjustments for lower earnings quality. Findings – The evidence suggests that investors possess idiosyncratic perceptions toward earnings management. Investors of income-decreasing firms tend to under-adjust for analyst optimism, while investors of income-increasing firms are inclined to over-adjust for analyst optimism. In addition, investors of both types of highly managed firms appear to under-adjust for earnings management. These investor characteristics result in a post-earnings announcement upward drift of cumulative abnormal returns (CARs) for income-decreasing firms and a downward drift for income-increasing firms. Practical implications – The findings strongly indicate that there is a significant mispricing at the earnings announcement date for the income-decreasing (P1) and income-increasing (P5) portfolios and the mispricing persists in the short run. Thus, it may be possible for investors to exploit the mispricing by holding a long position in P1 and a short position in P5. Originality/value – Prior studies concentrate on extreme cases of earnings management that are subject to securities and exchange commission (SEC) enforcement. In contrast to these studies, this paper focuses on the market reaction to earnings management, which may or may not lead to SEC enforcement actions.Investors, Market system, Organizational earnings

Agency Conflicts, Financial Distress, and Syndicate Structure: Evidence from Japanese Borrowers

This Version: October 2006We examine how borrower firm characteristics affect the size structure in the Japanese syndicated loan market for the 1999-2003 period. Consistent with the view by Lee and Mullineaux (2004), we find that syndicates are smaller when borrowers have higher credit risk, while firms with greater information asymmetry are associated with larger syndicates in Japan. These results are primarily driven by nonkeiretsu (non-business group) firms. This suggests that the role of enhanced monitoring and facilitated renegotiation is especially useful for banks participating in Japanese syndicated loan for non-keiretsu firms. On the other hand, information problems seem to be less severe for keiretsu (business group) firms which tend to have easier access to syndicated loan via the intermediation of in-house banks in the relevant syndicate. Finally, we find that keiretsu (non-keiretsu) firms have less (more) fraction of loan by their agent banks as the maturity rises. It appears that main banks of keiretsu firms with informational advantage are likely to retain less of the loan and form a more dispersed syndicate to "signal' that the loan is of high quality with increased maturity. This further confirms the view that information problems are less severe in the keiretsu firms