Effects of Limits-to-Arbitrage on Post Earnings Announcement Drift

Abstract

This paper examines whether post-earnings-announcement drift (PEAD) in the Koeran Stock Market is a consequence of the risk premium for omitted latent risk factors or of systematic mispricing from investors' delayed response to earnings news. To examine whether PEAD is still prominent after adjustment for risk factors, we form portfolios (SUE1~SUE4) sorted on standardized unexpected earnings (SUE). We find that value-weighted average excess raw returns and cumulative abnormal returns tend to monotonically increase across SUE portfolios. Further, the difference in average excess return between highest and lowest SUE portoflios (i.e., SUE4−SUE1), which is the return of the SUE-based zero-investment strategy, is positive and statistically significant. We also find that riskadjusted abnormal returns, which are computed from the well-known three models (i.e., CAPM, Fama-French three-factor model, and Fama-French five-factor model), still show a monotonic increasing pattern across SUE portfolios. The difference in abnormal return between highest and lowest SUE portfolios is also positive and statistically significant. Therefore, these results indicate that it is difficult to argue that PEAD is a consequence of the risk premium for omitted risk factors in the Korean stock market. We also examine the effect of limits-to-arbitrage on PEAD, and find that as the degree of limits-to-arbitrage is more profound, the degree of the drift is more prominent. That is, the difference, SUE4−SUE1, tends to increase in magnitude and statistical signiciance with the degree of limits-to-arbitrage. Furthermore, the difference in SUE4-SUE1 between the most and least severe limits-to-arbitrage portfolios (i.e., difference-indifference) is positive and statistically significant. These results indicate that PEAD is more profound as limits-to-arbitrage becomes more severe. In summary, this paper provides evidence supporting the arguments that PEAD in the Korean stock market may be a consequence of delayed response to unexpected earnings news due to limits-to-arbitrage, rather than a manifestation of the risk premium for omitted latent risk factors. To our knowledge, this paper is the first in the literature in Korea that comprehensively evaluates the two explanations for PEAD.

Corporate Social Responsibility and Post Earnings Announcement Drift: Evidence from Korea

“…This is because investors take longer to make investment decisions due to the lower the credibility of the disclosed information (e.g., due to a reliance on private information); thus, earnings information is slowly reflected in the stock price in the postannouncement period [28]. Furthermore, Lee et al [29] argued that disclosing management forecasts alleviates PEAD. Specifically, they found that PEAD decreased for companies that disclosed management sales forecasts and for more accurate forecasts.…”

“…Specifically, PEAD is less prominent in large companies than in small and mid-sized ones because the former provide more information to investors [26]. Additionally, providing management forecast information in proportion to the degree of information uncertainty significantly reduces PEAD [29].…”

“…To investigate the impact of CSR on PEAD, an extension of the regression model of Lee et al [28,29] was assessed:…”

“…In Equation ( 1), CAR measures the cumulative abnormal returns after the annual earnings announcement. Specifically, CAR(n) is the sum of the daily abnormal returns of a firm over the n days starting from the day after the earnings announcement [29,43,44]. Additionally, CAR over 30, 60, 90, and 120 trading day intervals was computed to examine whether the drift existed over longer periods.…”

“…SUE represents the standardized unexpected earnings. SUE was measured by subtracting consensus one-month-ahead analyst forecasts of earnings per share from actual earnings per share and dividing by the adjusted closing stock price [29,45].…”