The Effect of Risk on Price Responses to Unexpected Earnings

Abstract

We investigate the possibility that earnings response coefficients (ERCs) are increasing in total risk (i.e., the sum of systematic and unsystematic risk). As in prior risk-ERC studies, we model firm value by discounting expected dividends at risk adjusted rates. We argue that ERCs increase with total risk because total risk is positively associated with the sensitivity of dividend expectations to firm-specific news. This paper extends the investigation of the role of risk in returns-earnings relations initiated by Easton and Zmijewski [1989] and Collins and Kothari [1989] who point out that ERCs should decline with systematic risk because the dividend discount rate should increase with systematic risk. Our empirical work finds a robust positive relation between ERCs and total risk that is both economically and statistically significant; however, we find little empirical support for a relation between ERCs and systematic risk after controlling for the relation between ERCs and total risk.

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Keywords: Risk, ERC, Price-Earnings Relation

JEL Classification: M41, G12, G14