Event-Specific Uncertainty and its Expected Resolution Michael
Transcription
Event-Specific Uncertainty and its Expected Resolution Michael
Event-Specific Uncertainty and its Expected Resolution Michael Iselin Carlson School of Management University of Minnesota 321 19th Ave S. Minneapolis, MN 55455 [email protected] Andrew Van Buskirk* Fisher College of Business The Ohio State University 2100 Neil Avenue Columbus, OH 43210 [email protected] First Draft: March 2015 * Corresponding author We gratefully acknowledge financial support from the Carlson School of Management and the Fisher College of Business. Abstract Investor uncertainty, as measured by implied volatility, increases before anticipated events. We characterize this increase as “event-specific uncertainty” and examine it in the context of earnings announcements. We find that relative pre-earnings uncertainty is greatest when the announcement is most likely to resolve significant uncertainty (e.g., larger firms, firms with lower analyst coverage, firms with idiosyncratic earnings, and firms likely to issue a forecast). We focus on the consequences of event-specific uncertainty and first find that investors respond more strongly to an earnings surprise (i.e. larger ERC) when relative preearnings uncertainty is higher. We then show that event-specific uncertainty impacts the temporal realization of returns. Specifically, we find that a larger proportion of annual returns are realized during earnings announcement periods that are characterized by higher ex ante event-specific uncertainty. Importantly, we also examine other measures of total uncertainty and fail to find similar results. Overall, we show that the consequences of disclosure are a function of the uncertainty about the disclosed information, rather than uncertainty about firm value overall. We also show that the types of firms for which uncertainty is generally high are not the types of firms for which uncertainty is primarily resolved at earnings announcements. 1. Introduction Prior research documents that investor uncertainty, as represented by option-based implied volatilities, increases prior to earnings announcements and other anticipated information events (Patell and Wolfson 1979, 1981; Rogers et al. 2009). We examine this increase, which we characterize as “event-specific uncertainty”, to understand its determinants and to test predicted relations between event-specific uncertainty and event-period returns. Specifically, we interpret the ratio of pre-announcement implied volatility to baseline implied volatility as the extent to which investors believe the forthcoming earnings announcement period will resolve uncertainty (generate greater price movement) relative to the typical non-earnings period.1 We refer to this ratio as Relative Pre-Earnings Uncertainty and view it as a specific case of event-specific uncertainty. We expect Relative Pre-Earnings Uncertainty to be driven by the combined effect of: 1) pre-announcement investor uncertainty related to the topics expected to be discussed and 2) the expected likelihood that the upcoming disclosure will be effective in resolving that uncertainty, both of which are positively correlated with the ratio. We first show that Relative Pre-Earnings Uncertainty varies predictably with factors likely to precede relatively consequential information announcements.2 Some of these factors likely reflect an anticipation of more precise earnings announcement information: Larger firms, firms with more stable (less noisy) earnings, and firms with a history of issuing earnings forecasts have greater Relative Pre-Earnings Uncertainty. Other factors likely reflect inherent uncertainty about the firm (or an inability to obtain information from other sources): firms with 1 In theory, investors could expect the earnings period to resolve less uncertainty than the typical non-earnings period. However, prior research provides strong evidence that earnings announcement days experience more price movement and are more informative than random non-announcement days (e.g., Ball and Shivakumar 2008). 2 Note that we are interested in the characteristics of earnings announcements, rather than characteristics of just the firm’s earnings or the relevance of earnings in valuing the firm. 1 fewer analysts and firms whose earnings are less correlated with market-level or industry-level earnings have greater Relative Pre-Earnings Uncertainty. The focus of the paper then shifts to the relation between event-specific uncertainty and realized event-period returns. We first ask whether the investor response to earnings surprises increases with Relative Pre-Earnings Uncertainty, as models of Bayesian updating would predict (e.g., Holthausen and Verrecchia 1988; Kim and Verrecchia 1991b). Empirically, this prediction has received only mixed support, likely due to the difficulty of distinguishing uncertainty from other factors that influence how investors respond to new information. Our second question stems from a different prediction about the relation between uncertainty and returns: the claim that the pattern of realized returns should reflect the pattern of uncertainty resolution (Robichek and Myers 1966a; Epstein and Turnbull 1980). We build on the empirical framework of Ball and Shivakumar (2008), who quantify the importance of quarterly earnings announcements by estimating the proportion of annual returns associated with the 4 quarterly earnings announcements. We predict that realized returns are more heavily concentrated in earnings announcement periods when those earnings announcements have greater Relative Pre-Earnings Uncertainty.3 We find support for both of our predictions. First, we show that earnings-period returns are more sensitive to a unit of unexpected earnings (i.e., have larger ERCs) when Relative PreEarnings Uncertainty is greater. This finding is consistent with Bayesian investors responding more strongly to new information when they were more uncertain about that information before it was announced.4 Second, we show a positive correlation between Relative Pre-Earnings 3 This differs from predicting that earnings announcements earn larger risk premia when uncertainty is greater, because we are holding total annual return constant. 4 We acknowledge that this could indicate either greater pre-announcement uncertainty or a more precise earnings signal; both would lead to a higher ERC. In our empirical tests, though, we control for factors likely to capture the 2 Uncertainty and the Ball and Shivakumar (2008) measure of earnings informativeness. This result supports the claim that realized returns are concentrated in periods of greater (expected) uncertainty resolution. The magnitude of this relation is substantial: Ball and Shivakumar (2008) document an average abnormal adjusted R2 (their measure of informativeness) of about 5.8% for the 1990-2006 period. In our sample, the lowest quintile of Relative Pre-Earnings Uncertainty has an abnormal adjusted R2 of 5.6% while the highest quintile has an abnormal adjusted R2 of 14.4%.5 Moreover, the magnitude of the abnormal adjusted R2 increases monotonically moving from the lowest quintile of Relative Pre-Earnings Uncertainty to the highest quintile. We then rerun our two main tests using other proxies for uncertainty, including the median level of implied volatility (based on options without earnings announcements in their horizons), the pre-earnings level of implied volatility, and analyst dispersion. We find that ERCs are negatively associated with each of these measures. We interpret the combined results as evidence that investors do not necessarily respond more strongly to a signal when total uncertainty is high; instead, investors respond more strongly to a signal when uncertainty about that signal is high. In terms of our second test, we find no consistent relation between the proportion of returns attributable to earnings periods and either measure based on the level of implied volatility. We also find a strong negative relation between analyst dispersion and the proportion of returns attributable to earnings periods. This latter result is consistent with prior precision of the earnings signal (e.g., analyst dispersion and the volatility of the firm’s earnings series) and find that the relation between our uncertainty measure and ERCs is virtually unchanged. As a consequence, we interpret our results as stemming from investor pre-announcement uncertainty rather than variation in the precision of the signal. 5 The abnormal adjusted R2 reported in Ball and Shivakumar (2008) is increasing across time in their sample period. The average results for our sample are similar in magnitude to their results during the years in which the two samples overlap. 3 research (Imhoff and Lobo 1992) that concludes that analyst dispersion is a better measure of earnings noise than ex ante earnings uncertainty. Our paper provides new evidence on how investor uncertainty influences the way investors respond to new information, and how the expected resolution of uncertainty relates to the temporal realization of returns. Our results indicate that the choice of uncertainty measure matters a great deal in assessing these relations; the types of firms where uncertainty is generally high are not the types of firms for which uncertainty is primarily resolved at earnings announcements. 2. Prior research and hypothesis development Our paper examines the concept of event-specific uncertainty. We start by discussing prior research on investor anticipation of public disclosures. In Section 2.2, we present a simple disclosure-based model that provides the intuition for our measure of event-specific uncertainty. Sections 2.3 and 2.4 present hypotheses related to our measure. Because our paper touches upon several broad areas of accounting research, we necessarily reference only a small fraction of the existing research in each area. 2.1. Anticipation of public information releases Anticipated information events drive significant activity in capital markets, and researchers have examined several aspects of this activity. Analytical papers, including Gonedes (1980), Kim and Verrecchia (1991a), and McNichols and Trueman (1994), explore how the anticipation of public disclosure encourages the production and acquisition of private information. Empirical work provides corroborating evidence that sophisticated investors 4 acquire non-public information before anticipated events. Seppi (1992) shows that pre-earnings block trades reveal private information about impending earnings. El-Gazzar (1998) finds that firms with more institutional ownership have more of their earnings information preempted before the announcement. There is an entire branch of research that finds evidence of informed trading in the options market prior to information events (e.g., Amin and Lee 1997; Xing et al. 2010; Jin et al. 2012; Johnson and So 2012). Finally, Lee et al. (1993) and Yohn (1998) document one expected consequence of this private information acquisition: bid-ask spreads increase prior to an earnings announcement, and decline after the announcement as the perceived information advantage dissipates. Another consequence of anticipated disclosure is the expectation of temporarily elevated stock price volatility around the announcement. Even in the absence of private information, investors expect that earnings announcements will generate larger-than-normal price changes. This expectation of greater event-period price movement leads to an increase in call option prices as the announcement approaches, and can be measured with the implied volatility extracted from those call option prices. Empirically, research has shown a pattern of increasing implied volatility around both earnings announcements (Patell and Wolfson 1979, 1981; Isakov and Perignon 2001) and, to a lesser extent, management earnings forecasts (Rogers et al. 2009). Prior papers have decomposed the level of pre-announcement option volatility into two components: a baseline level of volatility and the increase in volatility as a result of the pending earnings announcement. Barth and So (2014) use options with different horizons to estimate these two components and then focus on the level of pre-announcement implied volatility and the associated volatility premium.6 Billings et al. (2014) examine short window changes in volatility 6 Specifically, they model expected earnings announcement volatility as + /252, where is expected is baseline volatility. They use 30- and 60-day standardized (excess) earnings announcement volatility and 5 ahead of earnings announcements and find that firms with larger changes are more likely to issue an earnings forecast concurrent with the earnings announcement. They also include the level of pre-announcement volatility in their tests and find that greater average uncertainty leads to a lower likelihood of issuing a forecast. They conclude that managers respond to increases in uncertainty by issuing volatility-decreasing information. Patell and Wolfson (1981) also characterize the level of volatility ahead of earnings announcements as a combination of baseline volatility and an increase in volatility ahead of earnings announcements. More similar to our study, they focus on the increase in volatility and conclude that firms with larger implied volatility increases demonstrate greater event-period volatility.7 We build on the work of Patell & Wolfson (1981) by investigating both the determinants of the pre-event increase in implied volatility and how that event-specific uncertainty manifests in the temporal realization of returns. In the next section, we present a simple disclosure-based model that characterizes the pre-event increase in implied volatility as event-specific uncertainty. 2.2. A simple model of event-specific uncertainty We start with a simple disclosure model presented in Verrecchia (2001). In this model, the firm has uncertain value, , with mean m and variance 1 ℎ. Investors receive a noisy signal, , equal to + (where has mean 0 and variance 1 ), and upon receiving the signal investors revise their beliefs about the value of the firm. The disclosure-related price change is a function of the surprise in the signal (the difference between the realization and the expectation) options (which have a different proportion of event and non-event days in their horizon) to infer the values of and . Their focus is on the relation between non-diversifiable volatility risk and risk premia. 7 Patell and Wolfson (1981) examine a series of option prices prior to earnings announcements to capture the implied event period volatility in options (as opposed to a baseline level of volatility in non-earnings periods). 6 and a disclosure response coefficient. The disclosure response coefficient indicates how strongly investors react to that surprise, and depends on the relative precision of the market’s prior information and the precision of the new information. As stated in Verrecchia (2001), the price change is: ∆ − = ) Equation (1) yields relatively straightforward and testable predictions.8 (1) First, price changes should be increasing in the earnings surprise. Second, price changes (per unit of surprise) should be increasing in the precision of the disclosure, n. Third, price changes (per unit of surprise) should be increasing in investors’ pre-announcement uncertainty (1 ℎ). Empirically, the first two predictions have been well documented. A substantial literature investigates the determinants of earnings response coefficients (ERCs), and demonstrates that price changes are an increasing function of earnings surprises (for a summary, see Kothari 2001). The second prediction is borne out by studies that show stronger investor response to forecast revisions issued by more accurate analysts (Clement and Tse 2003) as well as to management earnings forecasts when those forecasts are more precise (Baginski et al. 1993) or are accompanied by supplemental information that lends the forecast greater credibility (Hutton et al. 2003). The third prediction, that investors will respond more strongly to disclosure when uncertainty is greater, has been more difficult to establish. On one hand, Lang (1991) and Christensen (2002) examine small samples and identify a positive relation between uncertainty 8 In practice, the response to information releases is substantially more complicated than this model suggests, in part because the quality of one period’s disclosures influences investor precision prior to the next disclosure. Holthausen and Verrecchia (1988) develop a more robust model that incorporates both sequential information releases and multiple, potentially correlated, assets. We use this more simple model as an illustration, though, because it yields the straightforward empirical predictions that earlier empirical work has relied upon (Imhoff and Lobo 1992; Christensen et al. 2005; Bailey et al. 2006) 7 and investor response.9 On the other hand, Imhoff and Lobo (1992) use analyst dispersion as a proxy for investors’ ex ante uncertainty. They find that investor response is weaker when uncertainty is higher and conclude that analyst dispersion better captures the noise in earnings than investor uncertainty. (In terms of equation 1, analyst dispersion captures low n rather than low h.) Barron and Stuerke (1998) and Christensen et al. (2005) show a similar result with analyst dispersion. The conflicting results in prior research raise the question: what is the appropriate uncertainty measure in this context? In a world where investors periodically receive an estimate of fair value, it seems appropriate to use the level of pre-announcement uncertainty about fair value. In practice, though, investors receive a stream of information about different factors that influence estimated fair value to various degrees. Some of this information comes in periodic, scheduled releases like earnings announcements, while other information may come irregularly and unexpectedly. In this environment, total pre-announcement investor uncertainty reflects the likelihood of the anticipated disclosure being consequential, as well as the likelihood of other consequential information coming to light. As a result, firms with high levels of uncertainty may nonetheless exhibit weak investor response to their earnings announcements if that uncertainty relates to factors not discussed in the earnings announcement. As an extreme example, consider an early-stage pharmaceutical company with a single (potentially valuable) drug under FDA review. Investors have no information about when the FDA will release the results of their review, and the firm has no private information about the progress of the review. In this example, investor uncertainty will be high, because the value of the firm is likely to change dramatically upon the conclusion of the FDA review. If the firm 9 Lang (1991) examines a sample of 200 IPO firms and shows decreasing ERCs over time, arguing that investors’ uncertainty about the firm decreases over time. Christensen (2002) studies 92 Property & Casualty firms from 1989 to 1992 and shows that ERCs increase with firms’ exposure to catastrophe losses (the proxy for uncertainty). 8 announces earnings prior to the FDA’s announcement, investors will respond very little to unexpected earnings because current period unexpected earnings have little effect on the distribution of possible firm values. In this case, there would be a high level of pre-earnings uncertainty, but a weak investor response to unexpected earnings. Such an outcome would seem contrary to the model’s prediction that high investor uncertainty leads to stronger investor reaction.10 We expand the earlier model to incorporate the fact that investors typically do not receive periodic estimates of firm value, but instead receive periodic estimates of parameters they use as inputs to value the firm, some of which arrive on an unknown and unscheduled timetable. (This framework is consistent with Verrecchia (2001), who discusses the possibility of variables other than that are related to both firm value and the change in price.) In the spirit of multi-factor pricing models (e.g., Ross 1976), we assume that, over time, investors receive information about P parameters used as inputs to estimate firm value. Investors respond to these announcements as a function not only of the precision, surprise, and preannouncement uncertainty about each parameter, but also as a function of how relevant to the firm’s value that parameter is (i.e., how sensitive firm value is to changes in the parameter value). We use ωij to represent the relative importance of parameter i in valuing firm j and show price changes as a function of these variables: = ℎ + − ) + − ℎ + 10 ) + ⋯+ ℎ + − One could argue that the earnings signal conveys little information about firm value, and is therefore very imprecise, so that the weak investor response is consistent with the model represented in equation 1. This relatively broad notion of disclosure precision would be consistent with Kim and Verrecchia (1991a), who use the terms impact, quality, and precision as synonyms in their informal discussion. 9 (2) where is the reported value of parameter i which, prior to the release of has a mean of and variance 1 ℎ . ωij can be thought of as a pricing function for each parameter .11 In this framework, stock prices of different firms (or different securities of the same firm) can adjust differentially to common disclosures, holding the characteristics of those disclosures constant. For example, if firm j discloses current period earnings signal for firm j’s value) would be relatively large compared to , (the relevance of that , the relevance of that signal for firm k’s value (as we would observe if there is information transfer across firms j and k). As a consequence, firm j’s stock price would respond more strongly than firm k’s stock to the disclosure, even with common values of ℎ , , , and .12 What makes this framework useful in our context is that it allows for news about different parameters to be revealed in different temporal patterns. Investors may expect information about some parameters to be revealed uniformly or unpredictably over time (e.g., natural disasters or the actions of foreign governments), while they expect information about other parameters to be disclosed only at periodic information events (e.g., quarterly earnings).13 This difference in expected information flow leads to differences in how uncertainty is captured in option prices and implied volatilities. 11 A simple example would be the case of a private equity fund whose value depends upon the uncertain (and uncorrelated) values of its holdings. Investors would respond to the disclosure of holding 1’s value based on its − ), the relative precision of the disclosure, , and its weight in the fund’s portfolio, . In surprise general, though, price change will not be a linear function of the surprise in each parameter, particularly when some parameters (like growth rates or discount rates) influence price in a nonlinear manner. We simply view this equation as useful in presenting the intuition that the response to new information about a parameter depends upon the precision of that news and uncertainty about the parameter, rather than uncertainty about the firm overall. 12 The Holthausen and Verrecchia (1988) model includes multiple risky assets and allows for news about one asset to inform investors about the value of a second (or more) asset. 13 For simplicity, we ignore parameters that investors learn about from scheduled events that are not earnings announcements. For example, the earnings announcements of related firms or the release of FOMC monetary policy decisions. 10 In this setting, options’ implied volatilities will always reflect the expectation of news about the parameters that investors expect to learn about with equal likelihood each period. The magnitude of that expectation will be driven by investors’ uncertainty about each of those signals as well as the expected precision, possible surprise, and impact of those parameters on firm value (ω). For options with an anticipated information event in their horizon, though, there is an additional component of implied volatility that reflects anticipation of news about the parameters whose news release is specific to that information event, again driven by investor uncertainty about the signal and the other factors specific to that parameter. As a consequence, the difference in implied volatilities between options that have anticipated information events in their horizon compared to options that do not reflects the uncertainty about parameters whose disclosure is specific to that event. In the case of the earnings announcements that we study in this paper, we refer to the difference in implied volatility from these two types of options as Relative Pre-Earnings Uncertainty.14 We expect greater values of this measure to reflect circumstances where investors are particularly uncertain about earnings information (or non-earnings information expected to be released at the earnings announcement), where that information is consequential for firm value, and where the earnings announcement is likely to be effective in resolving the uncertainty. We employ this measure in our empirical tests, and discuss the use of alternative measures of uncertainty later in the paper. 2.3. The relation between event-specific uncertainty and investor response to new information 14 In our empirical tests, we use the natural logarithm of the ratio of pre-earnings implied volatility to baseline implied volatility. 11 Our first hypothesis relates to the link between investors’ pre-announcement uncertainty and their response to earnings announcements, and comes directly from the model in the prior section: We predict that investors will respond more strongly to an earnings surprise when their earnings-related uncertainty is greater. We formally state our first hypothesis as follows: H1: Investors will react more strongly to a unit of unexpected earnings when Relative Pre-Earnings Uncertainty is greater. There are two challenges in testing this hypothesis. First, firms issue a variety of information along with their quarterly earnings figure. Taken literally, our model suggests a different investor response to the news about each parameter ( − ) discussed at the earnings announcement, depending on the pre-event uncertainty about that parameter. Empirically, though, we observe neither the uncertainty specific to each parameter, nor the unexpected component of each parameter disclosed. For this reason we focus the analysis on earnings surprises and act as if the current period’s earnings realization is the only type of information disclosed at the earnings announcement. To the extent that Relative Pre-Earnings Uncertainty relates to non-earnings information expected to be disclosed at the earnings announcement, it will be more difficult to find support for our hypothesis. Second, our measure of Relative Pre-Earnings Uncertainty captures not just the uncertainty construct that we care about (pre-announcement investor uncertainty about earnings, or 1/h in the model), but rather the total expected price change, which is a function of the expected precision of earnings, the possible range of earnings surprise, and the relevance of earnings to firm value. We argue, though, that large earnings surprises are likely to be perceived as less precise (Subramanyam 1996), so that the expectation of a large absolute surprise would be offset by the expectation of a less precise signal. Empirically, Truong et al. (2012) show no statistical association between pre-earnings changes in implied volatility and the magnitude of 12 the earnings surprise. Therefore, it seems unlikely that our measure is affected to a large extent by the expectation of a potentially large earnings surprise. In our empirical tests, we also control for variables that we expect to capture the precision of the earnings signal (e.g., earnings volatility and analyst dispersion), which we believe leaves us able to draw inferences about ex ante uncertainty related to earnings information, weighted by the importance of earnings to the firm. 2.4. Relation between the timing of uncertainty resolution and realized returns Our second hypothesis relates to what Robichek and Myers (1966b) refer to as “The Manner in which Uncertainty is Expected to be Resolved over Time”. They emphasize that the rewards to bearing risk are not necessarily earned uniformly over time, but rather according to the way in which uncertainty is expected to be resolved over time. In a separate paper, Robichek and Myers (1966a) offer the example of a ship owner sending a vessel on a voyage that will return cargo of uncertain value. If the value of the cargo is unknown until the vessel’s return to port, then investors would earn a risk premium only when the uncertainty is resolved at the vessel’s arrival. Until that point, investors would earn only the risk-free rate. Adopting this argument, we hypothesize the following: H2: When Relative Pre-Earnings Uncertainty is higher, more of a firm’s annual stock return will be concentrated in its quarterly earnings announcement periods. Many papers have used the uncertainty resolution argument as motivation to test for the existence of an earnings announcement premium15, but we are aware of few papers that focus on the concentration of returns around information events, while holding total returns constant. The 15 Examples include Ball and Kothari (1991), Cohen et al. (2007), and Barber et al. (2013). Our research question differs from these papers in that they focus on the presence of short-window positive abnormal returns around earnings announcements. In contrast, our interest is in measuring the concentration of returns around earnings announcements while holding total annual return constant. 13 most relevant paper for our purposes is Ball and Shivakumar (2008), who examine the relative importance of earnings announcements as an information source. They quantify earnings announcement informativeness by regressing firms’ calendar-year stock returns on their four quarterly earnings announcement period returns. The R2 values from these regressions indicate the proportion of total annual information attributable to firms’ earnings announcements. Using this approach, Ball and Shivakumar conclude that earnings announcements contribute only a modest amount of information to annual returns. Although they do perform some sub-sample analyses,16 their primary focus is on estimating the amount of information in quarterly earnings announcements for the average firm. In contrast, our focus is on understanding how the Ball and Shivakumar (2008) measure of informativeness varies across firms and, more importantly, the linkage between Relative Pre-Announcement Uncertainty and the pattern of realized annual returns. We note that, unlike for the first hypothesis, the disclosure of non-earnings information at the earnings announcement does not pose a problem for testing this hypothesis. Our hypothesis is simply that when investors are uncertain about the impending announcement (regardless of which parameter they care about) more of the firm’s annual returns will be concentrated in that announcement period (regardless of which parameter news caused the returns). 3. Sample, uncertainty measurement, and descriptive statistics We start with a sample of quarterly earnings announcements disclosed from 1996 through 2014, and retain all observations with required financial statement, stock price, analyst estimates, and option information. Table 1 presents the distribution of the 130,002 observations across 16 Ball and Shivakumar (2008) perform subsample analyses on portfolios based on size, market-to-book, and leverage, but do not find a monotonic relation between earnings announcement informativeness and any of those variables. 14 years. The number of observations per year is generally increasing throughout the sample period as options become traded on more firms each year. We present three measures of investor uncertainty. The first, Pre-Earnings Uncertainty, is the implied volatility from a 30-day at-the-money option as of two trading days prior to reported earnings. The second, Average Uncertainty, is the median value of daily implied volatility from 30-day constant-maturity, at-the-money option prices over the window starting two days after the prior quarter’s earnings announcement and with maturities at least two days before the current quarter’s earnings announcement. The third measure of uncertainty, Relative Pre-Earnings Uncertainty, is the focus of our study. This measure starts with a calculation of excess firm volatility on each trading day, equal to implied volatility from a 30-day at-the-money option for the firm minus the 30-day VIX (index option implied volatility level). We calculate Relative Pre-Earnings Uncertainty as the ratio of the pre-earnings excess volatility to the median of daily excess volatility between earnings announcements.17 We characterize this measure as reflecting how important investors expect the earnings announcement to be in terms of resolving uncertainty about firm value, relative to the average non-earnings day. We present the descriptive statistics for these uncertainty measures as well as all other variables that we include in our tests in Table 2. Consistent with expectations and prior research, Pre-Earnings Uncertainty is, on average, greater than Average Uncertainty (0.49 vs. 0.45 at the mean, 0.44 vs. 0.41 at the median). The mean (median) value of Relative Pre-Earnings Uncertainty is 1.36 (1.16), which again is consistent with the well-documented pattern of 17 This allows for time-varying changes in market-wide volatility, which may include increased volatility in anticipation of clustered earnings announcements by other firms or economy-wide shocks to uncertainty. Our inferences are unchanged if we simply take the ratio of unadjusted pre-earnings implied volatility to median unadjusted implied volatility. 15 increasing uncertainty ahead of anticipated events (Patell and Wolfson 1979, 1981; Isakov and Perignon 2001). This table also shows that the firms/earnings announcements in our sample are fairly large, with a median market value greater than $1.5 billion, and well-followed, with a median analyst following of 4. Table 3 shows the correlation among the three measures of uncertainty, as well as the correlations between each of these measures and the other firm characteristics included in subsequent analyses. Although there is a significant increase in implied volatility prior to earnings announcements, there continues to be a substantial correlation (0.81) between the average level of implied volatility between earnings announcements and the level of implied volatility immediately prior to earnings announcements. Relative Pre-Earnings Uncertainty is positively associated with the pre-earnings level and negatively associated with the average (nonearnings) level of uncertainty. Importantly, Relative Pre-Earnings Uncertainty is slightly negatively correlated with the absolute value of the earnings surprise in the current period (0.08). This supports our claim that our measure of event-period uncertainty is not simply picking up expectations of the magnitude of the pending earnings surprise. 4. Empirical Results 4.1. Characteristics of firms with high EA uncertainty Before discussing the results of our hypothesis tests, we examine the characteristics of firms/earnings announcements that are associated with high levels of Relative Pre-Earnings Uncertainty. We regress the log of our measure, log(Relative Pre-Earnings Uncertainty), on variables that we expect to influence the relative importance of earnings announcements for investors. We subjectively classify these determinants into 4 groups: 16 • General firm characteristics (Size, Book-to-Market, Stock Return Volatility) • Analyst characteristics (Analyst Following, Analyst Dispersion) • The firm’s earnings characteristics (Prior Loss, Earnings Volatility, Earnings Non-Commonality) • Prior announcement characteristics (Magnitude of 3-day Return, magnitude of the earnings surprise, whether the firm issued a forecast) Table 4 presents the results of this regression.18 In terms of general firm characteristics, we find that earnings announcements are perceived to be relatively more important for large firms and for firms with less return volatility. One interpretation of the negative coefficient on Stock Return Volatility is that greater volatility between earnings announcements may result from more information about the firm being released in this interim period. That being said, each of these measures have been used to proxy for a variety of underlying constructs, so we are reluctant to draw many inferences based on these estimated coefficients. Of the two analyst characteristics, only Analyst Following is significantly associated with the perceived importance of earnings announcements; earnings are perceived to be less important when the firm has more analyst coverage. This outcome is consistent with the idea that analysts generate and release information about the firm throughout the period, and can effectively act as a substitute source of information for investors. There is no detectable relation between Analyst Dispersion and Relative Pre-Earnings Uncertainty. All three earnings characteristics are associated with the pre-earnings increase in uncertainty in intuitive ways. When the firm has reported a loss in the prior period (Loss in Prior Quarter), earnings announcements are perceived to be less important (or alternatively, less 18 The number of observations in this regression is significantly lower than in the overall sample primarily because of the Forecast at Last EA variable, which is available only from 2003 through the end of our sample. If we exclude the forecast variable, the number of observations used in the regression increases by about 50%. In this regression, Book-to-Market and Analyst Dispersion are significantly greater than 0, and all remaining variables have the same inference and statistical significance. 17 precise). This finding is consistent with the idea that losses are not expected to persist, and are thus less informative about the firm’s future cash flows (Hayn 1995).19 Along the same lines, when a firm’s earnings are volatile (Earnings Volatility), a single earnings report provides relatively less information about firm value. Finally, when earnings do not co-move with market-level or industry-level earnings (Earnings Non-Commonality), a firm’s earnings announcement is relatively more important because investors are less able to infer the firm’s performance from other sources (e.g., other firms’ earnings announcements). The final group of variables relates to characteristics of the firm’s prior earnings announcement, and again the associations are somewhat intuitive. If the prior earnings announcement generated a significant market reaction (|Prior EA 3-day Return|), investors are likely to infer that the current earnings announcement will do the same. This could be due to a variety of reasons, such as the firm tending to issue very detailed earnings releases, analysts generating significant complementary information, or the firm issuing information only during quarterly earnings announcements. We find a negative relation between the magnitude of earnings surprises in the prior quarter, which is consistent with Subramanyam’s (1996) model, in which large unexpected earnings are perceived as less precise signals. Finally, the likelihood that a firm will issue an earnings forecast along with its results increases the perceived importance of an upcoming earnings announcement. We proxy for this likelihood with a simple indicator variable (Forecast at Prior EA) equal to 1 if the firm issued a forecast with their prior earnings announcement. (The autocorrelation in forecasting is about 19 We similarly find a negative relation between Relative Pre-Earnings Uncertainty and the disclosure of a loss for the current period. However, our focus is on the determinants of pre-disclosure anticipation, so we use only proxies that are observable prior to the current earnings announcement. 18 0.80.) This positive association is consistent with the notion that management forecasts provide a substantial amount of information to investors (Beyer et al. 2010).20 Overall, the results in Table 4 support our claim that Relative Pre-Earnings Uncertainty captures investors’ expectation of how important/influential the upcoming earnings announcement will be. 4.2. Relation between announcement-specific uncertainty and investor response to unexpected earnings We next test hypothesis H1, which predicts investors will respond more strongly to a unit of unexpected earnings when Relative Pre-Earnings Uncertainty is greater. Table 5, Panel A shows the results of 4 regressions that model (signed) 3-day stock returns centered on quarterly earnings announcement dates. In each case, we estimate realized returns as a function of the analyst-based earnings surprise and allow that relation (i.e., the ERC) to vary depending on whether the earnings surprise is positive or negative. We also include calendar-quarter fixed effects to account for variation in market-wide discount rates and risk likely to affect ERCs (Kothari 2001): 3-day Return = α0 + α1Earnings Surprise + α2Negative Earnings Surprise + Quarter Fixed Effects + εi . (3) In the first column, we add to these variables just our variable of interest – Relative PreEarnings Uncertainty – as an interaction with the earnings surprise. Our test of H1 is whether 20 This result offers an alternative interpretation of the results shown in Billings et al. (2014). They show that managers are more likely to issue earnings forecasts when there has been a recent increase in implied volatility, and they interpret their results as evidence that managers respond to increased pre-earnings uncertainty by providing more information. An alternative interpretation consistent with our results is that investors anticipate the likelihood that an earnings forecast (or other consequential disclosure) will be made at the upcoming earnings announcement, and that anticipation manifests in greater announcement-specific uncertainty. When we include variables for both the lagged forecast decision and the current forecast decision, both are positively and significantly associated with Relative Pre-Earnings Uncertainty, with coefficients that are not statistically different from one another at the 10% level. 19 this interaction term is positively associated with signed returns or, said another way, whether ERCs are positively related to our measure of announcement-specific uncertainty. The results in Column 1 support our prediction – investors respond more strongly per unit of earnings surprise when their announcement-specific uncertainty is greater. In the next several columns, we add additional variables to assess the robustness of this relation. Column 2 adds the level of announcement-specific uncertainty, while Columns 3 and 4 add a variety of firm/earnings characteristics identified by earlier research as important determinants of earnings response coefficients (Kothari 2001). In each case, the interaction between announcement-specific uncertainty and 3-day returns is positive and significant at the p<0.01 level. Importantly, when we include Earnings Volatility and Analyst Dispersion (proxies for noise in earnings) with the other control variables, the coefficient of interest changes very little (0.594 in column 1 compared to 0.572 in column 3, and 0.581 in column 2 compared to 0.556 in column 4). The fact that including or excluding these measures of earnings precision has very little effect on our results gives us comfort that our measure is primarily capturing variation in ex ante investor uncertainty about earnings. In Panel B, we conduct the same tests using three alternative measures of uncertainty: the level of implied volatility immediately prior to the earnings announcement (Pre-Earnings Uncertainty), the average level of implied volatility between earnings announcements (Average Uncertainty), and the standard deviation of analyst earnings forecasts (Analyst Dispersion). In each case, we continue to focus on the interaction between the uncertainty proxy and the earnings surprise.21 If these alternative proxies capture investor uncertainty in the spirit of 21 We control for the full set of independent variables used in Column 4 of Panel A, but do not report the estimated coefficients on those variables for the sake of brevity. In untabulated tests, we also confirm that our results from Panel A are robust to including these additional uncertainty variables and their interaction with the earnings surprise. 20 Verrecchia (2001) and other disclosure models, we expect the interactions to be positive and significant. For each of the three proxies, we fail to find the predicted positive association between uncertainty and the intensity of investor response. For two of the three proxies (Average Uncertainty and Analyst Dispersion), we find a significantly negative relation between the uncertainty proxy and the strength of investor response. Although inconsistent with theorybased predictions, these associations are consistent with two ideas. First, as discussed in Imhoff and Lobo (1992), analyst dispersion is likely to be a better proxy for noisy earnings than for fundamental uncertainty. Second, what matters for understanding how investors respond to information is not their total pre-announcement uncertainty, but rather the uncertainty that is specific to the factors that are expected to be discussed in that announcement. 4.3. Relation between announcement-specific uncertainty and the relative informativeness of earnings announcements Our second hypothesis deals with the temporal realization of returns, and how the pattern of returns around earnings announcements relates to the relative uncertainty about those announcements prior to their release. We predict that a greater proportion of firms’ annual returns will result from earnings announcement periods when investors perceive more ex ante uncertainty about those earnings announcements. We test this hypothesis using the approach developed by Ball and Shivakumar (2008). They regress a firm’s annual returns on the firm’s four quarterly earnings announcement period returns during the same year, as follows: Ri(annual) = α0 + α1Ri(window1) + α2Ri(window2) In all cases, the Relative Pre-Earnings Uncertainty interaction continues to have a positive and significant association with earnings period stock returns. 21 + α3Ri(window3) + α4Ri(window4) + εi (4) Using annual cross-sectional regressions run each year, they interpret the R2 values from those regressions as “a measure of the proportion of the total information incorporated in share prices over a year that is associated with its four quarterly earnings announcements” (p. 976).22 They find that earnings announcements provide only a modest amount of information compared to what would be expected from a randomly-selected period from that year. While the primary interest of Ball and Shivakumar (2008) is in quantifying the importance of earnings announcements at the aggregate level, we are interested in whether cross-sectional variation in Relative Pre-Earnings Uncertainty leads to variation in their R2 measure. We predict that when investors expect more uncertainty resolution during earnings announcements (relative to an average non-earnings period), a greater proportion of annual returns will be concentrated in the earnings period. Similar to Ball and Shivakumar (2008) the window over which we calculate earnings announcement returns is the day before to the day after the announcement. Returns around each firm’s announcement that occurs in the first calendar quarter is denoted Ri(window1). Similarly, announcements from the second, third and fourth calendar quarter are denoted Ri(window2), Ri(window3) and Ri(window4), respectively. We use arithmetic buy-and-hold returns for both the annual return and the 4 announcement period returns. Our test proceeds as follows: we first measure Relative Pre-Earnings Uncertainty for each firm-quarter, then we sort firm-years into quintiles based on the average value of Relative Pre-Earnings Uncertainty for the four quarters of that year. We then run the regression in equation (2) by year and quintile resulting in a total of 90 values of adjusted R2, one for each of 22 Ball and Shivakumar (2008) point out that this approach does not rely upon market efficiency. Investor reaction that spills into other periods (e.g., a post-earnings announcement drift) will be captured by α coefficients that differ from 1. 22 the 5 quintiles and each year from 1996 – 2013. To calculate abnormal adjusted R2 for each regression we again follow Ball and Shivakumar (2008) and subtract from the adjusted R2 value the proportion that we would expect from a random day if returns were distributed i.i.d.23 We average coefficient estimates and abnormal adjusted R2 estimates for each Relative Pre-Earnings Uncertainty quintile across years and present the results in Table 6, Panel A. The right-most column of the table shows the average abnormal adjusted R2 values for each quintile. We observe a monotonic relation between Relative Pre-Earnings Uncertainty and the concentration of realized stock returns around quarterly earnings announcements – the lowest quintiles have abnormal adjusted R2 values of 5.6 and 8.9, while the highest two quintiles have abnormal adjusted R2 values of 13.5 and 14.4. These results validate the Robichek and Myers (1966a) claim that “the rate at which income is expected to be realized over time depends on the rate at which uncertainty is expected to be resolved over time” (p. 730). We next present a more formal test of whether the differences in abnormal adjusted R2 across quintiles are statistically significant. We regress the estimated abnormal adjusted R2 from each of the 90 regressions on the quintile ranking as follows: . = + )+ (5) Table 6 Panel B presents results of this regression and confirms the significance of the relation shown in Panel A. Specifically, abnormal adjusted R2 from the Ball and Shivakumar (2008) regression is significantly associated with the degree of pre-announcement uncertainty. A movement from one quintile to the next increases abnormal R2 by an estimated 2.219% (significant at the p<0.01 level). 23 Assuming i.i.d. daily returns, each day contributes 1/252 of the explanatory power for annual returns where 252 is the number of trading days in the year. We include 12 days in our earnings announcement return windows so the normal adjusted R2 is 12/total number of trading days in that year. 23 In Table 7, we examine whether different measures of uncertainty exhibit the same property. In Panel A, we assign firm-years to quintiles 1-5 based on the total level of implied volatility prior to the earnings announcement. We find no obvious relation between the quintile of pre-earnings uncertainty and abnormal R2. Instead, the two extreme quintiles show the lowest abnormal R2 (6.4 and 7.3), while the remaining three quintiles share approximately the same level of abnormal R2 (ranging from 10.5 to 11.3). A similar pattern holds in Panel B, where we sort firm-year observations based on Average Uncertainty, the median implied volatility for 30day options without earnings announcements in their horizons. The extreme quintiles have the lowest abnormal R2 values (8.2 and 6.5), while the three middle quintiles have comparable values (11.0 to 11.5). Panel C shows the results when we sort by analyst dispersion. Unlike the prior two panels, there is a monotonic relation – firms with the lowest level of analyst dispersion experience the greatest proportion of their annual return during quarterly earnings windows. This result is the opposite of what we would expect if analyst dispersion captures fundamental investor uncertainty, and is further evidence that it better captures the noise in reported earnings. We interpret the monotonic relation in Panel C as evidence that returns are concentrated in earnings announcements when firms issue earnings with less noise. Finally Panel D presents our formal test of the differences in the abnormal adjusted R2 across quintiles for the different quintile rankings in Panels A, B and C. This test confirms that there is not a linear relation between abnormal adjusted R2 and quintile ranking when quintiles are formed on the basis of Pre-Earnings Uncertainty or Average Uncertainty. However, the negative relation when quintiles are formed on the basis of Analyst Dispersion is statistically significant. Our interpretation of this finding is consistent with evidence in Tables 3 and 4 that 24 Relative Pre-Earnings Uncertainty is greater when analyst dispersion is lower; investors anticipate more uncertainty resolution when earnings have less noise. 5. Conclusion This paper examines event-specific uncertainty in the context of earnings announcements. We use the well-known increase in pre-earnings implied option volatility (Patell and Wolfson 1979, 1981) to measure that event-specific uncertainty in order to better understand its determinants and, more importantly, its consequences for realized event-period returns. We find that larger firms, firms with more stable earnings, and firms that tend to issue forecasts with their earnings announcement are more likely to experience increased levels of event-specific uncertainty. Firms that are covered by fewer analysts and have earnings that are less correlated with market and industry earnings also tend to have larger event-specific uncertainty. In other words, event-specific uncertainty is greatest when investors have less ability to infer earnings from alternative sources, and when the impending announcement is likely to be effective in resolving earnings-related uncertainty. We then look to the consequences of increased event-specific uncertainty. First, we show that when a firm has greater event-specific uncertainty, investors respond more strongly per unit of earnings surprise. This result does not hold for other measures of uncertainty, including analyst dispersion, the pre-earnings level of implied volatility, or the median non-earnings level of implied volatility. Our results indicate that investor response to new information is a function of investor uncertainty about the factors likely to be discussed in the upcoming announcement, rather than their total uncertainty about firm value. 25 Second, we show that when investors have greater earnings-specific uncertainty (relative to their uncertainty during non-earnings periods), their annual returns are more concentrated in their quarterly earnings announcement periods. This finding substantiates the Robichek and Myers (1966a) argument that returns for holding uncertain positions should only be earned when that uncertainty is resolved. 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What Does the Individual Option Volatility Smirk Tell Us About Future Equity Returns? Journal of Financial & Quantitative Analysis 45 (03):641-662. Yohn, T. L. 1998. Information Asymmetry Around Earnings Announcements. Review of Quantitative Finance and Accounting 11 (2):165-182. 29 Table 1 – Earnings announcement sample, by year Earnings Announcements 4,613 5,948 6,521 7,165 6,466 5,875 5,623 5,490 6,370 7,021 7,523 7,827 7,477 7,173 7,753 7,923 7,989 8,630 6,615 130,002 Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Total Table 1 Notes: This table shows the distribution of quarterly earnings announcements from 1996-2014. Observations are retained for all earnings announcements with available pre-earnings market value, financial statement information, and implied option volatility. 30 N 130,002 130,002 130,002 129,992 106,793 110,466 130,002 130,002 130,002 120,476 120,476 130,002 130,002 130,002 130,002 Mean 5,798.9 0.56 5.7 19.4% 0.018 0.043 0.49 0.45 1.36 -0.17% 0.57% 0.03% 0.34% 0.33% 6.10% Median 1,535.9 0.42 4.0 0 0.010 0.019 0.44 0.41 1.16 0.00% 0.23% 0.04% 0.12% 0.21% 4.22% Std. Dev. 13,161.2 0.70 4.8 0.3956954 0.024 0.075 0.23 0.21 0.84 1.03% 1.02% 0.62% 0.65% 8.29% 6.02% 25th Pctile 611.7 0.24 2.0 0 0.005 0.008 0.33 0.30 0.94 -0.31% 0.08% -0.04% 0.04% -3.88% 1.85% 75th Pctile 4,419.1 0.68 8.0 0 0.021 0.044 0.60 0.55 1.49 0.17% 0.59% 0.18% 0.33% 4.58% 8.30% 31 This table shows descriptive statistics for the firms/earnings announcements in our sample from 1996-2014. Market Value is the firm’s market value of equity two trading days prior to the reported earnings announcement date (in millions). Book-to-Market is the prior quarter’s shareholders’ equity divided by the market value of equity two trading days prior to the earnings announcement. Analyst Following is the number of analysts issuing earnings forecasts for the current quarterly period. Loss in Prior Quarter is an indicator variable equal to 1 if the firm’s income before extraordinary items was less than 0 in the prior quarter, and 0 otherwise. Earnings Volatility is the standard deviation of the firm’s prior 12 quarters of income before extraordinary items (deflated by average total assets). Analyst Dispersion is the standard deviation of analyst forecasts for the current quarter. Pre-Earnings Uncertainty is the implied volatility from a 30-day option measured two trading days prior to the earnings announcement. Average Uncertainty is the median value of the implied volatility from 30-day options based on closing prices between the last quarter’s earnings announcement and this quarter’s earnings announcement. Relative Pre-Earnings Uncertainty is the ratio of Pre-Earnings Uncertainty to Average Uncertainty, where both the numerator and the denominator are adjusted by the contemporaneous level of the VIX. Pre-Earnings Market Value Book-to-Market Analyst Following Loss in Prior Quarter Earnings Volatility Analyst Dispersion Pre-Earnings Uncertainty Average Uncertainty Relative Pre-Earnings Uncertainty Pre-Earnings Expectations Gap |Pre-Earnings Expectations Gap| Earnings Surprise |Earnings Surprise| 3-Day Earnings Period Return |3-Day Earnings Period Return| Table 2 Notes Variable Table 2 – Descriptive statistics All variables are winsorized at the 1% and 99% levels. 32 Expectations Gap is the difference between quarter t+1 earnings per share and analyst estimates for quarter t+1 earnings, deflated by stock price and measured prior to the quarter t earnings announcement. Earnings Surprise is quarter t actual earnings per share minus analyst estimates for quarter t earnings, deflated by stock price. 3-Day Earnings Period Return is the cumulative 3-day stock return around the earnings announcement. (2) Pre-Earnings Uncertainty (1) Average Uncertainty 1.00 0.81*** -0.25*** -0.50*** 0.16*** 0.83*** -0.08*** 0.16*** 0.31*** 0.32*** -0.07*** 0.39*** -0.16*** -0.07*** 0.35*** 0.01 0.32*** (3) Relative PreEarnings Uncertainty 33 This table shows correlations between our three measures of uncertainty and the variables described in Table 2. Pre-Earnings Uncertainty is the implied volatility from a 30-day option measured two trading days prior to the earnings announcement. Average Uncertainty is the median value of the implied volatility from 30-day options based on closing prices between the last quarter’s earnings announcement and this quarter’s earnings announcement. Relative Pre-Earnings Uncertainty is the natural logarithm of the ratio of Pre-Earnings Uncertainty to Average Uncertainty, where both the numerator and the denominator are adjusted by the contemporaneous level of the VIX. See Table 2 for the definitions of all other variables. (1) Average Uncertainty (2) Pre-Earnings Uncertainty 1.00 (3) Relative Pre-Earnings Uncertainty 0.05*** 1.00 (4) Market Value -0.46*** 0.20*** (5) Book-to-Market 0.15*** -0.06*** (6) Lagged Volatility 0.80*** -0.11*** (7) Analyst Following -0.08*** 0.04*** (8) Analyst Dispersion 0.15*** -0.04*** (9) Loss in Prior Quarter 0.27*** -0.10*** (10) Earnings Volatility 0.29*** -0.09*** (11) Earnings Non-commonality -0.05*** 0.04*** (12) |Prior EA 3-day Return| 0.38*** -0.02*** (13) Prior EA Management Forecast -0.11*** 0.12*** (14) Current EA Earnings Surprise -0.07*** 0.00 (15) |Current EA Earnings Surprise| 0.33*** -0.08*** (16) Current EA 3-day Return 0.00 0.01*** (17) |Current EA 3-day Return| 0.39*** -0.00 Table 3 Notes ***, **, * indicates a correlation significantly different from 0 at the 1%, 5%, and 10% level, respectively. Table 3 – Correlations with uncertainty measures Table 4 – Characteristics associated with abnormal pre-earnings uncertainty Dependent variable: log(Relative Pre-Earnings Uncertainty) Independent Variable Log(Market Value) 0.061 *** (23.30) Book-to-Market 0.001 (0.26) Stock Return Volatility -1.021 *** (-5.13) Analyst Following -0.003 *** (-5.82) Analyst Dispersion 0.022 (0.65) Loss in Prior Quarter -0.037 *** (-6.41) Earnings Volatility -0.572 *** (-5.87) Earnings Non-Commonality 0.011 *** (6.98) |Prior EA 3-day Return| 0.306 *** (8.61) |Prior Earnings Surprise| -2.240 *** (-7.27) Forecast at Last EA 0.077 *** (13.20) N R2 60,474 0.056 Table 4 Notes: ***, **, * indicates a correlation significantly different from 0 at the 1%, 5%, and 10% level, respectively. 34 This table shows the results of an OLS regression where the dependent variable is the natural logarithm of Relative Pre-Earnings Uncertainty, equal to the ratio of Pre-Earnings Uncertainty to Average Uncertainty, where both the numerator and the denominator are adjusted by the contemporaneous level of the VIX. The independent variables are defined as follows: Log(Market Value) is the natural logarithm of the firm’s market value two trading days prior to the earnings announcement. Book-to-Market is the ratio of the prior quarter’s shareholders’ equity value divided by the market value of equity two measured two trading days prior to the current earnings announcement. Stock Return Volatility is the standard deviation of daily logged stock returns between the prior and current quarter’s earnings announcement. Analyst Following is the number of analyst issuing an earnings forecast for the current quarterly period. Analyst Dispersion is the standard deviation of analysts’ earnings estimates for the current quarterly period. Loss in Prior Quarter is an indicator equal to 1 if the prior quarters’ earnings before extraordinary items was negative, and 0 otherwise. Earnings Volatility is the standard deviation of the firm’s prior 12 quarters of earnings deflated by average total assets. Earnings NonCommonality is based Brown and Kimbrough (2011) and starts with rolling regressions of 20 quarters of the firm’s quarterly ROA on both the market and industry-level ROA for the same periods. Earnings Non-Commonality is the log of [unexplained variance (1-R2) divided by 1 minus unexplained variance]. |Prior EA 3-day Return| is the absolute value of the 3-day stock return around the firm’s prior quarterly earnings announcement. |Prior Earnings Surprise| is the absolute value of the prior quarter’s earnings surprise, deflated by pre-earnings stock price. Forecast at Prior EA is an indicator variable equal to 1 if I/B/E/S records a forecast issued in the 3-day period around the prior quarter’s earnings announcement, and 0 otherwise. All continuous variables are winsorized at the 1% and 99% levels. Standard errors are clustered by firm. 35 (see notes following Panel B) Levels of the 4 Variables Interacted with earnings? N R2 Year-Quarter Fixed Effects Earnings Surprise*Analyst Dispersion Earnings Surprise*Book-to-Market Earnings Surprise*Earnings Volatility 130,002 0.067 Yes 36 130,002 0.067 Yes Dependent variable: 3-day stock return around quarterly earnings announcements Independent Variable (1) (2) Earnings Surprise 3.764 *** 3.784 *** (36.29) (36.41) Negative Earnings Surprise -1.557 *** -1.587 *** (-12.41) (-12.61) Earnings Surprise*Relative PreEarnings Uncertainty 0.594 *** 0.581 *** (5.26) (5.15) Relative Pre-Earnings Uncertainty 0.002 *** (5.46) Earnings Surprise*Log(Market Value) Table 5 – Relation between uncertainty and investor response to unexpected earnings Panel A: Using announcement-specific uncertainty (Relative Pre-Earnings IV) Included 91,312 0.084 Yes -0.002 (-0.03) -6.690 *** (-2.62) -0.421 *** (-6.09) -8.158 *** (-18.52) 0.572 *** (4.09) (3) 5.926 *** (13.93) -1.987 *** (-11.14) Included 91,312 0.084 Yes 0.556 (3.97) 0.002 (4.63) -0.002 (-0.03) -6.716 (-2.63) -0.419 (-6.06) -8.156 (-18.51) *** *** *** *** *** (4) 5.935 *** (13.96) -1.997 *** (-11.19) Table 5 – Relation between uncertainty and investor response to unexpected earnings Panel B: Using alternative measures of uncertainty Dependent variable: 3-day stock return around quarterly earnings announcements Independent Variable (1) (2) (3) Earnings Surprise 5.895 *** 5.955 *** 5.860 *** (14.88) (15.11) (13.74) Negative Earnings Surprise Earnings Surprise* PreEarnings Uncertainty Pre-Earnings Uncertainty -1.833 *** (-12.09) -1.916 *** (-12.72) -0.172 (-1.07) 0.003 *** (3.60) Earnings Surprise * Average Uncertainty -0.618 *** (-3.84) Average Uncertainty -0.003 *** (-3.42) Earnings Surprise*Analyst Dispersion -8.146 *** (-18.48) Analyst Dispersion N R2 Year-Quarter Fixed Effects -1.957 *** (-10.93) -0.051 *** (-10.99) 106,793 0.074 Yes 106,793 0.075 Yes 91,312 0.083 Yes Table 5 Notes: ***, **, * indicates coefficients statistically different from 0 at the 1%, 5%, and 10% levels, respectively. 37 This table shows the results of OLS regressions with the same dependent variable: 3-day (signed) stock returns surrounding firms’ quarterly earnings announcements. Earnings Surprise is the difference between reported earnings per share (from I/B/E/S) and the mean of all analyst estimates subsequent to the prior earnings announcement, deflated by the pre-announcement stock price. Negative Earnings Surprise is equal to Earnings Surprise if Earnings Surprise is negative, and 0 otherwise. Relative Pre-Earnings Uncertainty is the natural logarithm of the ratio of Pre-Earnings Uncertainty (the implied volatility of a 30-day option two trading days prior to the earnings announcement) to Average Uncertainty (the median implied volatility from 30-day options between earnings announcement periods), where both the numerator and the denominator are adjusted by the contemporaneous level of the VIX. The regressions shown in Panel B also include the Market Value, Book-to-Market, and Earnings Volatility variables (both levels and interactions with the earnings surprise) from Panel A as dependent variables, but those coefficient estimates are not presented. All continuous variables are winsorized at the 1% and 99% levels. Standard errors are clustered by firm. 38 0.236 0.173 0.135 0.102 0.079 1 (low) 2 3 4 5 (high) 1.340 1.364 1.245 1.356 1.096 1st Quarter 0.953 1.168 1.393 1.264 1.464 2nd Quarter 1.050 1.251 1.170 1.370 1.346 3rd Quarter 0.970 0.873 0.913 0.983 1.040 4th Quarter 90 0.139 N R2 Table 6 Notes: This table shows estimates from an annual regression of the form: 4.16 ** (2.13) 39 2.219 *** (3.77) Constant Independent Variable Quintile of Relative Pre-Earnings Uncertainty Panel B: Regression of Ball and Shivakumar (2008) R2 on quintile of Relative Pre-Earnings Uncertainty Intercept Relative PreEarnings Uncertainty Quintile Panel A: Quintiles of Relative Pre-Earnings Uncertainty 5.6 8.9 11.6 13.5 14.4 Abnormal R2 Table 6 – Relation between announcement-specific uncertainty and the informativeness of quarterly earnings announcements 40 Panel B shows the results from an OLS regression of abnormal adjusted R2 on the quintile of Relative Pre-Earnings Uncertainty. where annual is firm i’s calendar year stock return and window1, window2, window3, and window4 are the 3-day stock returns around firm i’s four quarterly earnings announcements during the same calendar year. Regressions are performed by year and quintile of Relative Pre-Earnings Uncertainty, with the coefficients (averaged by quintile over all years) presented in Panel A. The right-most column of Panel A shows the average abnormal adjusted R2 value from the annual regressions, where abnormal adjusted R2 is calculated each year (and within each quintile) as the adjusted R2 from the regression minus its expectation assuming i.i.d. daily returns. Ri(annual) = α0 + α1Ri(window1) + α2Ri(window2)+ α3Ri(window3) + α4Ri(window4) + εi 0.133 0.136 0.144 0.161 0.199 1 (low) 2 3 4 5 (high) Intercept 0.122 0.128 0.141 0.162 0.194 Average Uncertainty Quintile 1 (low) 2 3 4 5 (high) 1.370 1.202 1.090 1.143 1.030 1st Quarter 1.414 1.172 1.116 1.143 0.921 1st Quarter Panel B: Quintiles of Average Uncertainty Intercept Pre-Earnings Uncertainty Quintile Panel A: Quintiles of Pre-Earnings Uncertainty 41 1.167 1.268 1.186 1.014 0.738 2nd Quarter 1.257 1.261 1.158 0.935 0.757 2nd Quarter 1.209 1.343 1.062 1.095 0.994 3rd Quarter 1.435 1.275 1.044 1.111 0.967 3rd Quarter 1.024 0.985 1.012 0.946 0.798 4th Quarter 1.088 1.021 0.922 1.025 0.862 4th Quarter 6.5 11.0 11.5 11.3 8.2 Abnormal R2 7.3 10.5 10.5 11.3 6.4 Abnormal R2 Table 7 – Relation between alternative measures of uncertainty and the informativeness of quarterly earnings announcements 0.219 0.166 0.135 0.110 0.083 1 (low) 2 3 4 5 (high) 1.282 1.033 1.344 1.162 1.466 1st Quarter 1.205 1.031 1.302 1.330 1.386 2nd Quarter 1.144 1.205 1.130 1.167 1.305 3rd Quarter 0.832 1.021 1.082 1.045 1.182 4th Quarter 90.000 0.000 N r2 Table 7 Notes: 8.887 *** (5.20) Constant Independent Variable Uncertainty Quintile 42 90.000 0.001 10.133 *** (5.64) Uncertainty quintiles formed based on: Pre-Earnings Average Uncertainty Uncertainty 0.102 -0.190 (0.20) (-0.35) 90.000 0.046 12.758 *** (7.21) 7.6 8.1 9.5 10.0 12.2 Abnormal R2 Analyst Dispersion -1.098 ** (-2.06) Panel D: Regression of Ball and Shivakumar (2008) R2 on Quintile of Alternative Uncertainty Measures Intercept Analyst Dispersion Quintile Panel C: Quintiles of Analyst Dispersion Table 7 (continued) – Relation between alternative measures of uncertainty and the informativeness of quarterly earnings announcements 43 Panel D shows the results from separate OLS regressions of abnormal adjusted R2 on the quintile of each uncertainty measure for the three panels using the three different uncertainty measures as the sorting variable. where annual is firm i’s calendar year stock return and window1, window2, window3, and window4 are the 3-day stock returns around firm i’s four quarterly earnings announcements during the same calendar year. Regressions are performed by year and quintile of uncertainty measures, where uncertainty measures are Pre-Earnings Uncertainty (Panel A), Average Uncertainty (Panel B), and Analyst Dispersion (Panel C). The coefficients (averaged by quintile over all years) are presented in Panels A, B, and C. The rightmost column of each panel shows the average abnormal adjusted R2 value from the annual regressions, where abnormal adjusted R2 is calculated each year (and within each quintile) as the adjusted R2 from the regression minus its expectation assuming i.i.d. daily returns. Ri(annual) = α0 + α1Ri(window1) + α2Ri(window2)+ α3Ri(window3) + α4Ri(window4) + εi This table shows estimates from an annual regression of the form: