Earnings Predictability, Information Asymmetry, and Market Liquidity

Abstract

This study examines the association between earnings predictability and the behavior of the bid-ask spread (transaction costs), the adverse selection cost component of the spread, and trading volume around quarterly earnings announcements. We also consider the impact of earnings volatility and frequency of accounting changes on our earnings predictability measure. Consistent with the theoretical work in the literature (e.g., Glosten and Harris (1988)), we argue that more noisy (less predictable) earnings signals aggravate the information asymmetries between privately informed investors and market-makers in the capital markets. To compensate for this informational disadvantage, the market-makers' increase in the bid-ask spread at the time of an earnings announcement is expected to be more pronounced for firms with less predictable earnings.Consistent with our differential earnings predictability argument, we find an increase in the adverse selection component of the bid-ask spread on the day of and the day prior to the earnings announcement date for firms with less predictable earnings. In contrast, we find no evidence of a significant change in the adverse selection component of the bid-ask spread around quarterly earnings announcements of firms with highly predictable earnings. Consistent with earlier studies, we find significant increases in trading volume around earnings announcements. Ceteris paribus, this higher volume should lead to lower spreads. The increase in spreads we document therefore suggest that the increased volume is not sufficient to offset the increase in the adverse selection cost faced by market-makers. Our results suggest that the predictability of the earnings signal affects transactions costs and may impact the firm's cost of capital, a matter of interest to corporate managers and shareholders.

JEL Classification: D82, M41, G12