An Analytical Measure of Market Underreaction to Earnings News

Abstract

Prior studies have provided a number of possible explanations for delayed market reactions to earnings announcements. However, there has been relatively little effort to predict the magnitude of the post-earnings announcement drift (PEAD). We show that the squared correlation coefficient (p2 ) between order imbalance and earnings surprise determines the magnitude of market underreaction to earnings surprises and PEAD = k p2, where k is the information content of earnings. We discuss several testable implications of our analytical results, including a model-implied measure of information asymmetry that arises from the differential information processing ability of traders.

Keywords: Strategic trading, Information asymmetry, Information precision, Liquidity demander, Liquidity provider, Order imbalance, Information content, Price impact

JEL Classification: G14