Firm Opacity Lies in the Eye of the Beholder

Abstract

Given the central role of firm opacity in most finance theories, empirical proxies that identify firm opacity correctly should allow for more powerful tests of these theories. The last decade has seen adoption of several different empirical proxies that aim to capture firm opacity. However, there is no study that has compared all of these measures. In this paper, we investigate how these different measures are related to each other. We classify the main empirical measures of firm opacity into three broad categories; those based on behavior of stock returns, those based on information produced by intermediaries such as stock analysts, and those based on market microstructure. Since opacity of depositary institutions has been focus of a number of recent studies, it provides a natural laboratory to test these different proxies. Our results show that while there is only a limited correlation among various opacity measures, most of them indicate that banks are less opaque compared to non-banks. Our failure to find consistent evidence on bank opacity suggests that the results are highly dependent on the opacity measure employed by the researcher. To measure the effectiveness of various opacity proxies, we use credit rating initiation as a significant shock to the firm information environment. We adopt a difference-in-difference approach, by comparing newly rated firms with “unchanged” firms, i.e. already rated or unrated firms. Our results suggest that the number of analysts and the price impact (as measured by the Amihud’s (2002) ratio) appear to be the most reliable proxies for firm opacity.

Keywords: Firm Opacity, rating initiation, analysts coverage

JEL Classification: G19, G21, D89