Academic journal article Economic Perspectives

Earnings Announcements, Private Information, and Liquidity

Academic journal article Economic Perspectives

Earnings Announcements, Private Information, and Liquidity

Article excerpt

Introduction and summary

Efficient financial markets facilitate the smooth transfer of money from those who save to those with profitable investment opportunities. Such markets generally exhibit high levels of trading volume and widespread market participation. Investors are willing to participate because they are convinced that the prices at which securities can be bought and sold are reasonably efficient. For example, a market participant should be able to buy or sell a share of stock in XYZ company at a price very close to the present discounted value of the market's best estimate of XYZ's future dividend payments. (1)

So where do these market estimates come from? There are two main types of information underlying these estimates--one, information that is common to all market participants (I call this public information), and two, information that is specific to individual investors (I call this private information). An example of public information in this context would be a news release about company XYZ that might be expected to move the company's share price. A company making a surprisingly good earnings announcement typically sees an immediate rise in its stock price. Bad news generally has the reverse effect. Clearly, this type of information impacts market prices.

What is less clear is whether and to what extent private information impacts stock prices. On most trading days, there is no obvious "news" (that is, public information) regarding the value of a particular stock, yet stocks still trade and often show noticeable price changes. Some widely held stocks trade every few seconds on all trading days. Although some of this activity can be linked to public news, much of the trading and related price changes occur when there is no easily observable event or publicly conveyed information believed to be relevant to a given company's stock price. Suppose that an investor places a large order to purchase shares of XYZ on a day when no public news about XYZ is released. Depending on the characteristics of this trade, the price of XYZ may change. For example, if market participants believe this trade was made by an investor who believes the stock is undervalued, others may revise their own expectations and afford shares of XYZ a higher price. Alternatively, participants observing a large purchase order may attribute the purchase to the fact that the given purchaser of XYZ is a manager of an index fund that is well known to have been receiving large inflows of investment capital. Thus, the purchase of XYZ contains no information about the value of XYZ shares. In this case, one might expect the purchase to have a more limited impact on the stock's price. In reality, the underlying purpose of individual trades is not generally known, and therefore one can characterize trades as containing some degree of private information.

Understanding how both public and private types of information influence security prices is one of the main goals of financial market microstructure analysis. Earnings announcements are perhaps the most visible form of public information. At the most extreme, insider trading by an executive knowing the contents of a forthcoming news release is an example of private information. However, private information can simply be thought of as all information about a given security price that is not known by all who trade it. For example, a mutual fund manager's decision to reduce the holding of a given stock would be considered private information capable of affecting security prices.

Private information, however, can be even less tangible. Differing opinions as to the implications of an earnings announcement may generate important private information, since some may believe the optimal response to the news is to buy a security, whereas others may wish to sell. It is the collective trades of market participants that move prices. Market microstructure analysis presumes that trading is necessary to determine prices because it conveys private information regarding the value of the underlying asset. …

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