Question

1. analysis in terms of capital market response to unexpected announcements. (500 words)

Answer 1

Financial information about any company is vital while appraising the value of stock prices. Investors do consider this public financial information to assess the potential future perspective of any firm. Earnings represent the measure of firm’s profits or loss from business activities and events during a stipulated period. Dividend and earnings announcements are the two most important financial information used by the investors for decisions regarding buying and selling of any firm’s share. A firm’s return represents the capital market’s measure of performance of the firm over a period. The information of earnings announcements is used by capital market as a yardstick to assess the profitability and financial strength of any firm. New financial information is normally unpredictable by definition; otherwise, it would have been reflected in the share price far before the announcement.

Earnings based on current period for any firm reflects two sorts of information: current period wealth created for equity shareholders and about possible future earnings which will be ultimately distributed to the shareholders. Beaver (1968) described the following three links between earnings announcements and share prices:

1. earnings of current period provide information to predict earnings of future period;

2. earnings of current period provide information for expected dividends of future periods; and

3. earnings of current period provide information to determine the present value of expected future dividends.

The capital market, prior to releasing of announcements, creates expectations and speculations about announcements. The market so reacts to the unexpected announcement of a firm’s announced earnings if they differ from the market expected earnings. If the earnings announcement surpasses the expected earnings (normally deliberated to be a good news), share prices will have a surge, and if earnings announcement tilts toward lower side against the expected earnings (seemingly considered as bad news), the share price will decrease. For the market to be considered efficient as per efficient market hypothesis (EMH), a quick and correct adjustment in the share price should be in place after earnings and dividend announcement. The correct adjustment indicates that the prices neither overreact nor underreact to any specific information announcement. It is mandatory for the announcements, whether considered good or bad for any company, that they should be correctly reflected in the share price of the company after they are made public. An event study based on earnings announcement which is reckoned as the central variable of interest and earnings announcements can be used to test the efficiency of any company or market as a whole.

Event study methodology helps to find the promptness of share price movement to newly available financial information to the capital market. For the past four decades, EMH has been the focus of finance field, and EMH’s empirical testing has been applied by a number of ways and using different event studies. In their pivotal work, Landsman and Maydew (2002) indicated that after positive earnings surprises, stock prices tend to take a surge and vice versa.

Fama (1970) established that EMH can be further classified into three forms: weak, semi-strong and strong form of market efficiency. When historic market data and past prices are fully reflected in share prices but are unable to predict future prices, any market with this element is considered a weak form. Any market is considered as semi-strong form when all publicly available information is fully reflected in the share price. Finally, any market will be considered as strong form efficient when all available public and private source information is fully reflected in the share price. To determine its weak and semi-strong form, early empirical tests on EMH are conducted. It is the semi-strong form-efficient market where investors cannot use published information as well as historical prices to earn abnormal returns. The semi-strong efficiency of the market is tested on the earnings announcement information of any company and its prompt and correct adjustment in the share price of the company.

note - please appreciate the work