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Differential Interpretation of Public Information: Estimation and Inference

  • Xuguang Sheng
  • Maya Thevenot

We propose a new measure of differential interpretation in the context of a Bayesian learning model, which allows us to abstract from other sources of disagreement, such as differences in priors. We then develop a likelihood ratio statistic for testing the null hypothesis that agents interpret public information identically. Using financial analysts’ earnings forecasts, we find evidence that there is significant heterogeneity in the interpretation of public information among investors. In addition, we validate our new measure of differential interpretation and demonstrate its superiority over other proxies, such as Kandel and Pearson’s (1995) and Garfinkel’s (2009) metrics. Finally, we find that differential interpretation increases firm cost of capital, which has important implications to regulators, managers and academics.

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File URL: http://american.edu/cas/economics/research/upload/2013-3.pdf
File Function: First version, 2013
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Paper provided by American University, Department of Economics in its series Working Papers with number 2013-03.

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Date of creation: 2013
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Handle: RePEc:amu:wpaper:2013-03
Contact details of provider: Web page: http://www.american.edu/cas/economics/

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  11. Bamber, Linda Smith & Barron, Orie E. & Stober, Thomas L., 1999. "Differential Interpretations and Trading Volume," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(03), pages 369-386, September.
  12. Jon A. Garfinkel & Jonathan Sokobin, 2006. "Volume, Opinion Divergence, and Returns: A Study of Post-Earnings Announcement Drift," Journal of Accounting Research, Wiley Blackwell, vol. 44(1), pages 85-112, 03.
  13. Doukas, John A. & Kim, Chansog (Francis) & Pantzalis, Christos, 2006. "Divergence of Opinion and Equity Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 41(03), pages 573-606, September.
  14. Sheng, Xuguang & Thevenot, Maya, 2012. "A new measure of earnings forecast uncertainty," Journal of Accounting and Economics, Elsevier, vol. 53(1), pages 21-33.
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  17. Orie Barron & Xuguang Sheng & Maya Thevenot, 2013. "Information Environment and The Cost of Capital," Working Papers 2013-003, The George Washington University, Department of Economics, Research Program on Forecasting.
  18. Lahiri, Kajal & Sheng, Xuguang, 2008. "Evolution of forecast disagreement in a Bayesian learning model," Journal of Econometrics, Elsevier, vol. 144(2), pages 325-340, June.
  19. Robert Bloomfield & Paul E. Fischer, 2011. "Disagreement and the Cost of Capital," Journal of Accounting Research, Wiley Blackwell, vol. 49(1), pages 41-68, 03.
  20. Edwin J. Elton, 1999. "Presidential Address: Expected Return, Realized Return, and Asset Pricing Tests," Journal of Finance, American Finance Association, vol. 54(4), pages 1199-1220, 08.
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  22. Eugene Kandel & Ben-Zion Zilberfarb, 1999. "Differential Interpretation Of Information In Inflation Forecasts," The Review of Economics and Statistics, MIT Press, vol. 81(2), pages 217-226, May.
  23. Kandel, Eugene & Pearson, Neil D, 1995. "Differential Interpretation of Public Signals and Trade in Speculative Markets," Journal of Political Economy, University of Chicago Press, vol. 103(4), pages 831-72, August.
  24. Tkac, Paula A., 1999. "A Trading Volume Benchmark: Theory and Evidence," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(01), pages 89-114, March.
  25. Easley, David & Hvidkjaer, Soeren & O’Hara, Maureen, 2010. "Factoring Information into Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 45(02), pages 293-309, April.
  26. Rowland K. Atiase & Bipin B. Ajinkya & Alex K. Dontoh & Michael J. Gift, 2011. "The Fundamental Determinants Of Trading Volume Reaction To Financial Information: Evidence And Implications For Empirical Capital Market Research," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 34(1), pages 61-101, 03.
  27. Karl B. Diether & Christopher J. Malloy & Anna Scherbina, 2002. "Differences of Opinion and the Cross Section of Stock Returns," Journal of Finance, American Finance Association, vol. 57(5), pages 2113-2141, October.
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