Disclosure Processing Costs and Crash Risk: Evidence from Risk Factor Disclosures

Abstract

We study the relationship between disclosure processing costs and stock price crash risk using the setting of risk factor disclosure (RFD). We posit that, given the high disclosure processing costs of RFDs and differential investors’ information processing abilities, sophisticated investors can deduce more useful information from RFDs than other investors. Therefore, as more information is disclosed in RFDs, larger divergence of opinion arises, foreshadowing higher stock price crash risk. Consistent with this prediction, we find that the amount of information disclosed in a firm’s RFDs is positively associated with its future stock price crash risk. We also document an increase in short-sellers trading activities and divergence of opinions after the filing of 10-Ks with more RFDs. In addition, the positive association between RFDs and crash risk is more pronounced when short sellers face more binding trading constraints and higher arbitrage risks. Finally, we provide evidence that integration costs of RFDs appear to be the main obstacle to disclosure processing. Our findings are related to regulators’ concern about the effectiveness of RFDs and contribute to the literature on stock price crash risk by suggesting that more downside disclosure may not pre-empt future stock price crash risk.

Keywords: Disclosure processing costs, Risk factor disclosure, Stock price crash risk

JEL Classification: D91, G12