Value-at-Risk Disclosure, Cost of Equity Capital, and Investor Reaction
37 Pages Posted: 13 Sep 2007
Date Written: September 2007
Using a sample of 24 US banks from 1997 to 2004, we examine the relationship between value-at-risk (VAR) for trading activities and banks' cost of equity capital. We show that the implied cost of equity capital and the bid-ask spread, both proxying for the cost of equity capital, is positively related to VAR, as well as a quality indicator based on bank technical sophistication. The results are consistent with the claims that VAR effectively captures bank trading risk, and that investors care about banks' risk-taking activities. We next examine whether investors fully understand the implication of VAR to future volatility in trading revenues and utilize it in the pricing process. Our test cannot reject the null that bank stock price has fully incorporated the predictability of VAR.
Keywords: Value-at-risk, Market risk disclosure, cost of equity capital, information asymmetry
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