A New Metric of Market Underreaction to Earnings Announcements: An Empirical Test*

• Author: Kee H. Chung,Steve C. Lim,Oliver Kim,Sean Yang
• DOI: http://doi.org/10.1111/ajfs.12308
• Date: 01 August 2020
• Published date: 01 August 2020

A New Metric of Market Underreaction to

Earnings Announcements: An Empirical Test*

Kee H. Chung**

School of Management, University at Buffalo, The State University of New York (SUNY), United States

School of Business, Sungkyunkwan University, Republic of Korea

Oliver Kim

Robert H. Smith School of Business, University of Maryland, United States

Steve C. Lim

Neeley School of Business, Texas Christian University, United States

Sean Yang

College of Business, Oregon State University, United States

Received 8 July 2019; Received in current form (1

st

revision) 28 January 2020; Accepted 9 April 2020

Abstract

This paper provides empirical evidence that the squared correlation coefficient between order

imbalance and earnings surprise (COE) measures market underreaction and predicts the

*The authors thank the editor (Kwangwoo Park) and two anonymous referees for valuable

comments and suggestions. The authors also thank Stephen Brown, Rick Cazier, David Hir-

shleifer, Sahn-Wook Huh, Paul Irvine, Jack Jiang, Robert Kim, Sangwan Kim, Michael Kim-

brough, Ruby Lee (2018 AAA discussant), Larry Lockwood, David Ng, Jeffrey Ng, Claudia

Zhen Qi, Steven Sherwood, Inho Suk, Hongping Tan, Cristian Tiu, Cihan Uzmanoglu, Bob

Vigeland, Zhichen Wang, William Wempe, Mao Ye, Woongsun Yoo, and Lingyin Zhu; ses-

sion participants at the 2014 Northern Finance Association conference, the 2014 Financial

Management Association conference, the 24th Annual Conference on Financial Economics

and Accounting, the 8th Annual Lone Star Accounting Research Conference, the 2013 Mid-

Atlantic AAA Conference, Western AAA Conference, 2018 Southwest AAA, and 2018 AAA

conference; and seminar participants at Chinese University of Hong Kong, City University of

Hong Kong, KAIST Graduate School of Finance & Accounting, Texas Christian University,

University of Texas at Arlington, and Yonsei University for useful comments and discussions.

Steve Lim gratefully acknowledges research support from the Neeley School of Business. An

earlier version of this paper was circulated under the title “Information asymmetry, informa-

tion content, and the measurement of underreaction to earnings announcements.”

**Corresponding author: School of Management, University at Buffalo, The State University

of New York (SUNY), Buffalo, NY 14260, United States. Tel: +1-716-645-3262. email:

keechung@buffalo.edu.

Asia-Pacific Journal of Financial Studies (2020) 49, 517–547 doi:10.1111/ajfs.12308

©2020 Korean Securities Association 517

post-earnings announcement drift. We find strong evidence that COE during the announce-

ment period predicts price movements (returns) during the post-announcement period in

the expected direction. We find qualitatively similar results using risk-adjusted returns (i.e.,

Fama-French, Carhart, and Pastor-Stambaugh factor alphas), suggesting that well-known risk

factors do not explain the profitability of trading strategy based on COE.

Keywords Strategic arbitrage; Information asymmetry; Market underreaction; Liquidity

demander; Liquidity provider; Order imbalance

JEL Classification: G14

1. Introduction

Market reactions to earnings announcements have long been a topic of interest

to finance and accounting researchers.

1

While some researchers interpret post-

earnings announcement drift (PEAD) as evidence of market underreaction to

earnings announcements (Bernard and Thomas, 1989), others suggest omitted

risk factors as another possible explanation for PEAD (Kim and Kim, 2003;

Sadka, 2006). This paper sheds additional light on market underreactions to

earnings announcements using an analytical model of PEAD developed by Chung

et al. (2019).

Chung et al. (2019) develop a mark et underreaction metric from the simple

intuition that when some trad ers fail to fully understand th e pricing implication

of earnings news, other t raders who better unders tand the pricing implica tion

will capitalize on it throug h strategic trading. In the ir model, price reflects ear n-

ings information in two ways. Pri ce fully and instantly reflect s the earnings

information used by both the info rmed liquidity demander and the l iquidity

provider. Neither the liquidi ty demander’s order size nor the to tal order imbal-

ance is related to this porti on of earnings information b ecause no trader can

profitfromit.

The other portion of earnings information, used only by the liquidity demander,

is incorporated into stock price through the strategic order placement of the liquid-

ity demander, which gives rise to a positive correlation between order imbalance

and earnings surprise. Price reflects this portion of earnings information only par-

tially because the liquidity provider cannot perfectly infer it due to the strategic

exploitation of information advantage by the liquidity demander. When the infor-

mation asymmetry between the liquidity demander and provider is higher, a larger

portion of earnings information gets into price during the post-earnings announce-

ment period through the liquidity demander’s order. Based on this insight, Chung

et al. (2019) show that PEAD =k•COE, where kis the information content of

1

For instance, prior research shows that PEAD is smaller for firms with more institutional

investors (Atkins et al., 2012), larger size (Foster et al., 1984), and more analyst coverage

(Bhushan, 1994).

K. H. Chung et al.

518 ©2020 Korean Securities Association