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Limited market participation and asset prices in the presence of earnings management

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  • Bo Sun
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Abstract

We examine the role of earnings management in explaining the properties of asset prices and stock market participation. We demonstrate that investors' uncertainty about the extent of manipulation can cause excess movements in stock price relative to fluctuations in output. When faced with information asymmetry about fundamentals in the presence of earnings management, investors demand a higher equity premium for bearing the additional risk associated with their payoffs. In addition, when investors have heterogeneous beliefs about managerial manipulation, the dispersion in belief endogenously gives rise to limited stock market participation. Our model suggests that the increasing stringency of corporate governance and varying composition of investors may have played a role in the contemporaneous run-up of market participation rates in the recent years.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 1019.

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Date of creation: 2011
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Handle: RePEc:fip:fedgif:1019

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Keywords: Earnings management ; Stocks - Rate of return;

References

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  1. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
  2. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," Journal of Political Economy, University of Chicago Press, vol. 110(4), pages 825-853, August.
  3. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-74, May.
  4. Allen, F. & Gale, D., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers 2-92, Wharton School - Weiss Center for International Financial Research.
  5. Williamson, Stephen D., 1994. "Liquidity and market participation," Journal of Economic Dynamics and Control, Elsevier, vol. 18(3-4), pages 629-670.
  6. H. Henry Cao & Tan Wang & Harold H. Zhang, 2005. "Model Uncertainty, Limited Market Participation, and Asset Prices," Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1219-1251.
  7. Detemple, Jerome B, 1986. " Asset Pricing in a Production Economy with Incomplete Information," Journal of Finance, American Finance Association, vol. 41(2), pages 383-91, June.
  8. Illoong Kwon & Eunjung Yeo, 2008. "Overstatement and Rational Market Expectation," Discussion Papers 08-07, University at Albany, SUNY, Department of Economics.
  9. Haliassos, Michael & Bertaut, Carol C, 1995. "Why Do So Few Hold Stocks?," Economic Journal, Royal Economic Society, vol. 105(432), pages 1110-29, September.
  10. John G. Riley, 1976. "Informational Equilibrium," UCLA Economics Working Papers 071, UCLA Department of Economics.
  11. Pok-sang Lam & Stephen G. Cecchetti & Nelson C. Mark, 2000. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?," American Economic Review, American Economic Association, vol. 90(4), pages 787-805, September.
  12. Goldman, Eitan & Slezak, Steve L., 2006. "An equilibrium model of incentive contracts in the presence of information manipulation," Journal of Financial Economics, Elsevier, vol. 80(3), pages 603-626, June.
  13. Jose A. Scheinkman & Wei Xiong, 2003. "Overconfidence and Speculative Bubbles," Journal of Political Economy, University of Chicago Press, vol. 111(6), pages 1183-1219, December.
  14. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  15. Wang, Jiang, 1993. "A Model of Intertemporal Asset Prices under Asymmetric Information," Review of Economic Studies, Wiley Blackwell, vol. 60(2), pages 249-82, April.
  16. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, vol. 92(2), pages 323-36, May.
  17. Stein, Jeremy C, 1989. "Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior," The Quarterly Journal of Economics, MIT Press, vol. 104(4), pages 655-69, November.
  18. Annette Vissing-Jorgensen, 2002. "Limited Asset Market Participation and the Elasticity of Intertemporal Substitution," NBER Working Papers 8896, National Bureau of Economic Research, Inc.
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