Improved Understanding of Market Efficiency

A one-off event provided HKUST researchers with an unparalleled opportunity to investigate a “hot topic” related to stock markets: post-earnings announcement drift, or PEAD. It is defined as a significantly positive relation between currently announced earnings “surprises” (when results are above or below expectations) and subsequent stock returns. What drives PEAD? What is it correlated with? Why is it stronger for some firms and not others? Why does it not even appear to exist in some countries?

But while the topic has long attracted a great deal of interest from researchers in the US, international evidence is limited and inconclusive. Mingyi Hung, Xi Li and Shiheng Wang endeavored to fill this void and investigate the effect of an unprecedented improvement in non-US firms’ financial-reporting quality on changes in PEAD, thereby providing fresh evidence on the existence and explanations of PEAD, and improving understanding of market efficiency worldwide. One explanation for the unclear portrait of PEAD in global studies is that it is a balanced outcome of various factors jointly determined by a country’s institutional environment, which can affect PEAD in opposite directions.

The researchers took advantage of the 2005 mandatory adoption of International Financial Reporting Standards (IFRS) worldwide. This information “shock” was one of the biggest events in the history of financial reporting, affecting thousands of companies worldwide, thus offering a unique and powerful opportunity for testing their predictions and shedding light on the underlying reasons for PEAD. It is known that an exogenous “shock” such as this has a direct effect on one major driver of PEAD: uncertainty.  The event also allowed them to use a DID (difference-in-differences) approach by comparing changes in PEAD for firms in adoption countries with the changes in PEAD for firms in non-adoption countries. The sample consisted of 1,921 “treatment” firms from 18 countries that mandated IFRS, and 4,049 firms from 12 “benchmark” countries that did not adopt IFRS.

They found that the treatment firms experienced a decrease in PEAD subsequent to the information shock. In addition, they observed that this effect was more pronounced among firms with less distraction, more sophisticated investors, lower transaction costs, and lower arbitrage risks. These results are consistent with the explanation of PEAD being driven by limited investor attention and limits to arbitrage. They further found that the decrease in PEAD was greater among firms with greater changes in financial reporting, an increase in analyst forecast accuracy and institutional ownership, or a reduction in limits of arbitrage. The paper provided supporting evidence to the mispricing explanation of PEAD, characterized as investors’ underreaction to earnings news, particularly as a result of limited attention, in an international setting.

The study was the first to provide the mispricing explanation in an international setting. Its other significant contributions include the findings on limited investor attention and limits to arbitrage as important driving forces, as well as showing that disclosure regulations can improve market efficiency.

WANG, Shiheng

Associate Professor

HUNG, Mingyi

Head, Fung Term Professor of Accounting, Chair Professor