Asset Returns with Earnings Management
Board of Governors of the Federal Reserve System - Division of International Finance - International Banking and Finance Section
The paper investigates stock return dynamics in an environment where executives have an incentive to maximize their compensation by artificially inflating earnings. A principal-agent model with financial reporting and managerial effort is embedded in a Lucas asset-pricing model with periodic revelations of the firm's underlying profitability. The return process generated from the model is consistent with a range of financial anomalies observed in the return data: volatility clustering, asymmetric volatility, and increased idiosyncratic volatility. The calibration results further indicate that earnings management by individual firms does not only deliver the observed features in their own stocks, but can also be strong enough to generate market-wide patterns.
Number of Pages in PDF File: 67
Keywords: Earnings management, Stock returns, Financial anomalies, Volatility clustering, GARCH, Optimal contract
JEL Classification: D82, D83, G12, G14working papers series
Date posted: September 24, 2009 ; Last revised: October 5, 2009
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