Foreign Investors' Reaction to Reduced Profitability - Does Governance Matter?

Abstract:     
Following recent literature we hypothesize that when a firm's expected future earnings fall foreign investors will more likely suffer from moral hazard than domestic investors. A downward revision in a firm's expected future earnings should thus make foreign investors sell the firm's shares more extensively than domestic investors. We test this hypothesis on profit warnings issued at the Helsinki Stock Exchange. Our results reveal that in the wake of profit warnings foreign investors will predominantly sell, domestic investors picking up the net sales by foreigners. Our proxy for the magnitude of surprise in the warning is the most important variable in explaining the degree of foreign dominance among sellers. The relative strength of the foreign investor sell out reaction also depends on characteristics of the firm that issued the warning. Better corporate governance cushions the reaction by reducing insider and managerial moral hazard, while a higher degree of perceived information asymmetry strengthens it.

Keywords: profit warnings, home bias, moral hazard

JEL Classifications: G14, G30

Working Paper Series