Do Stock Market Investors Understand the Risk Sentiment of Corporate Annual Reports?

54 Pages Posted: 26 Apr 2006  

Feng Li

Shanghai Advanced Institute of Finance, Shanghai Jiaotong University

Date Written: April 21, 2006

Abstract

I test the stock market efficiency with respect to the information in the texts of annual reports. More specifically, I examine the implications of corporate annual reports' risk sentiment for future earnings and stock returns. I measure the risk sentiment of annual reports by counting the frequency of words related to risk or uncertainty in the 10-K filings. I find that an increase in risk sentiment is associated with lower future earnings: Firms with a larger increase in risk sentiment have more negative earnings changes in the next year. Risk sentiment of annual reports can predict future returns in a cross-sectional setting: Firms with a large increase in risk sentiment experience significantly negative returns relative to those firms with little increase in risk sentiment in the twelve months after the annual report filing date. A hedge portfolio based on buying firms with a minor increase in risk sentiment of annual reports and shorting firms with a large increase in risk sentiment generates an annual Alpha of more than 10% measured using the four-factor model including the Fama-French three factors and the momentum factor.

Keywords: Annual report, risk sentiment, earnings, stock returns

JEL Classification: D80, G12, G14, M41, M45

Suggested Citation

Li, Feng, Do Stock Market Investors Understand the Risk Sentiment of Corporate Annual Reports? (April 21, 2006). Available at SSRN: https://ssrn.com/abstract=898181 or http://dx.doi.org/10.2139/ssrn.898181

Feng Li (Contact Author)

Shanghai Advanced Institute of Finance, Shanghai Jiaotong University ( email )

211 West Huaihai Road
Shanghai, Shanghai 200030
China

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