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Stock Return Dynamics under Earnings Management

  • Xiaotong Wang

    (Penn State University)

  • Heng-fu Zou

    (World Bank)

This paper explores how earnings management influences asset returns and return volatility via real economic activity. In the model, firms smooth earnings via the costly and economically suboptimal intertemporal transfer of assets and liabilities. As a result, the firm's stock return follows a process that conforms to an EGARCH-like statistical model. The key idea is that real earnings management generates an unobservable cost, and the market has to infer the underlying wealth of the firm from the smoothed reported earn-ings series. This framework may help explain why asset returns underreact to good news and overreact to bad news, while no news is always good news to the market. Empirical evidence that earnings innovations impact future return volatility, in line with the model's predictions, is found in the data.

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Paper provided by China Economics and Management Academy, Central University of Finance and Economics in its series CEMA Working Papers with number 331.

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Length: 36 pages
Date of creation: 23 Mar 2008
Date of revision:
Handle: RePEc:cuf:wpaper:331
Contact details of provider: Web page: http://cema.cufe.edu.cn/

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  1. Ron Kasznik, 2002. "Does Meeting Earnings Expectations Matter? Evidence from Analyst Forecast Revisions and Share Prices," Journal of Accounting Research, Wiley Blackwell, vol. 40(3), pages 727-759, 06.
  2. Adrian R. Pagan & G. William Schwert, 1990. "Alternative Models For Conditional Stock Volatility," NBER Working Papers 2955, National Bureau of Economic Research, Inc.
  3. Abarbanell, Jeffery & Lehavy, Reuven, 2003. "Biased forecasts or biased earnings? The role of reported earnings in explaining apparent bias and over/underreaction in analysts' earnings forecasts," Journal of Accounting and Economics, Elsevier, vol. 36(1-3), pages 105-146, December.
  4. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1995. "Investment analysis and price formation in securities markets," Journal of Financial Economics, Elsevier, vol. 38(3), pages 361-381, July.
  5. Paul A. Gompers & Joy L. Ishii & Andrew Metrick, 2002. "Corporate Governance and Equity Prices," Center for Financial Institutions Working Papers 02-32, Wharton School Center for Financial Institutions, University of Pennsylvania.
  6. Engle, Robert F & Ng, Victor K, 1993. " Measuring and Testing the Impact of News on Volatility," Journal of Finance, American Finance Association, vol. 48(5), pages 1749-78, December.
  7. John R. Graham & Campbell R. Harvey & Shiva Rajgopal, 2004. "The Economic Implications of Corporate Financial Reporting," NBER Working Papers 10550, National Bureau of Economic Research, Inc.
  8. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
  9. Timothy C. Johnson, 2001. "Return Dynamics when Persistence is Unobservable," Mathematical Finance, Wiley Blackwell, vol. 11(4), pages 415-445.
  10. Nelson, Daniel B, 1991. "Conditional Heteroskedasticity in Asset Returns: A New Approach," Econometrica, Econometric Society, vol. 59(2), pages 347-70, March.
  11. Lawrence R. Glosten & Ravi Jagannathan & David E. Runkle, 1993. "On the relation between the expected value and the volatility of the nominal excess return on stocks," Staff Report 157, Federal Reserve Bank of Minneapolis.
  12. Geert Bekaert & Guojun Wu, 1997. "Asymmetric Volatility and Risk in Equity Markets," NBER Working Papers 6022, National Bureau of Economic Research, Inc.
  13. Engle III, Robert F., 2003. "Risk and Volatility: Econometric Models and Financial Practice," Nobel Prize in Economics documents 2003-4, Nobel Prize Committee.
  14. David Burgstahler & Michael Eames, 2006. "Management of Earnings and Analysts' Forecasts to Achieve Zero and Small Positive Earnings Surprises," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 33(5-6), pages 633-652.
  15. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
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