Clear and Liquid: The Interaction of Firm Disclosure and Trader Competition

Abstract

In an economy where traders absorb information partially, we study the effect of disclosure accuracy and disclosure clarity on financial markets. Accuracy measures how precisely a disclosure identifies the firm's fundamentals, whereas clarity measures how well traders understand the disclosure. Increasing clarity promotes competition among informed traders more so than it increases the information asymmetry between informed traders and market makers. Increasing accuracy has the opposite effect. Trading volume increases monotonically in clarity, while liquidity has a U-shaped relationship with clarity if competition among traders is intense. Volume and liquidity both decrease in accuracy due to adverse selection among different market participants. Moreover, traders' attention to disclosure is hump-shaped in clarity, but increasing in accuracy. Trading profits mimic the patterns of attention, but only under intense competition. Overall, our results suggest that the current trend of increasing complexity in firm disclosures is detrimental to liquidity and volume.

Keywords: Competition, Bounded Rationality, Accuracy, Clarity

JEL Classification: D53, G14, M41, D82