Question

Clever tests to discriminate between alternative explanations. LaPorta, Lakonishok, Shleifer, and Vishny (“Good News for Value Stocks,” Journal of Finance, June 1997) study the returns on stocks on the few days surrounding their quarterly earnings announcements (relative to various expected return benchmarks). They find that on average, high-B/M stocks earn 0.9% around an earnings announcement. In contrast, low-B/M stocks earn an average of -0.1% around an earnings announcement. The difference is statistically significant.

(i) High returns around earnings announcements are more likely to occur if the earnings surprise is _______. (Fill in the blank with “positive” or “negative”.)

(ii) Discuss whether the return pattern found by LaPorta et al. (1997) around earnings announcements is more consistent with the irrational expectations (behavioral) view, or the risk factor (efficient markets) view of the book-to-market effect, and explain your logic.

Answer 1

(i) High returns around earnings announcements are more likely to occur if the earnings surprise is _______. (Fill in the blank with “positive” or “negative”.)

The answer is positive.

With a larger than expected earnings, the share price usually goes up disproportionately than expected and this gives a bump to the returns more than what was anticipated.

(ii) Discuss whether the return pattern found by LaPorta et al. (1997) around earnings announcements is more consistent with the irrational expectations (behavioral) view, or the risk factor (efficient markets) view of the book-to-market effect, and explain your logic.

The return patterns around earnings announcement is an example of behaviorial pattern exhibiting as more investors flock to buy the stock which has shown better earnings thus driving up the price. In an efficient market, this information would already be built into the price and thus there would not be any appreciable change in price post earning announcement.