The Volatility of Return Revisions and Financial Statement Literacy in Emerging Markets: The Case of Cross‐listed Chinese Firms

• DOI: http://doi.org/10.1111/jbfa.12180
• Author: Steven X. Wei,Jeffrey L. Callen,Karen M.Y. Lai
• Published date: 01 May 2016
• Date: 01 May 2016

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(5) & (6), 572–596, May/June 2016, 0306-686X

doi: 10.1111/jbfa.12180

The Volatility of Return Revisions and

Financial Statement Literacy in Emerging

Markets: The Case of Cross-listed

Chinese Firms

JEFFREY L. CALLEN,KAREN M.Y. LAI AND STEVEN X. WEI∗

Abstract: Are foreign investors in emerging markets more financial statement literate than

domestic investors? If so, this conjecture implies that foreign (domestic) investors are more

likely to revise their return expectations to cash flow (discount rate) news. It also implies that

cash flow news and discount rate news are likely to be uncorrelated when evaluating return

revisions by domestic investors, whereas cash flow news and discount rate news are likely to be

negatively correlated when evaluating return revisions by foreign investors. The Chinese equity

markets yield robust empirical results that are consistent with both hypotheses.

Keywords: variance decomposition, domestic versus foreign investors, Chinese equity markets

1. INTRODUCTION

This study investigates whether foreign equity investors in emerging markets react

differently in revising equity returns to cash flow news (shocks) than domestic equity

investors. Although domestic equity investors in emerging markets are likely to be

more knowledgeable about local conditions than foreign investors, foreign investors in

emerging markets are also likely to be more financial statement literate than domestic

∗The first author is with the Rotman School of Management at the University of Toronto.The second author

is with the Faculty of Business and Economics, Monash University, and the third author is with the School

of Accounting and Finance, Hong Kong Polytechnic University. The authors appreciate helpful comments

from Bruce Mizrach, Timothy Chue, Byoung Kang, Hung Wan Kot, Gary Li, Liya Liu, Wilson Tong,Yi Zhang

and seminar/conference participants at the Asian Finance Association International Conference, the China

International Conference in Finance, the Bank of Finland, Beijing University, China Europe International

Business School, Hong Kong Baptist University, Hong Kong Polytechnic University,Shanghai University of

Finance and Economics, the University of International Business and Economics, and Xiamen University.

Wei acknowledges financial support from the Hong Kong Polytechnic University Research Grant G-U179.

(Paper received December 2014, revised version accepted January 2016)

Address for correspondence: Jeffrey L. Callen, Rotman School of Management, University of Toronto, 105

St. George Street, Toronto ON, Canada.

e-mail: callen@rotman.utoronto.ca

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investors.1This is especially plausible if domestic investors in emerging markets are

mainly retail and foreign investors in emerging markets are mainly institutional.

Indeed, beginning with Ball and Brown (1968), extensive prior research has

documented that financial statements are part of the information set that US and

European investors use to arrive at equity price estimates (i.e., that financial statement

numbers are value-relevant). In particular, it is well recognized by the accounting

literature that financial statements are especially useful to equity investors because

they provide information about the firm’s expected future cash flows. Therefore, to the

extent that investors are financial statement literate, they should be better at evaluating

the implications of cash flow news for equity prices and, therefore, more likely to react

in revising their equity return expectations to cash flow shocks than investors who are

less financial statement literate. As a consequence, if foreign investors in emerging

markets are truly more financial statement literate than domestic investors, foreign

investors are more likely to revise their return expectations to cash flow news than

domestic investors so that cash flow news should drive return revisions for foreign

investors.2Moreover, given that revisions to returns are tautologically due either to

cash flow news or to discount rate news – see below – implies in turn that domestic

investors are necessarily more likely to revise their expectations to discount rate news

than are foreign investors so that discount rate news should drive return revisions for

domestic investors.3

There is a further implication for revisions to returns if foreign investors in

emerging markets are more financial statement literate than domestic investors.

Specifically, if foreign investors are more financial statement literate, they are also

more likely to evaluate the implication of cash flow news for discount rates since both

cash flows and discount rates determine returns. In contrast, if domestic investors are

not financial statement literate, they are more likely to disregard the implication of

cash flow news on discount rates. Thus, we should expect to find that cash flow news

and discount rate news are uncorrelated in emerging markets when evaluating return

revisions by domestic investors but, contrariwise, we should expect to find that cash

flow news and discount rate news are correlated when evaluating return revisions by

foreign investors.4

The literature provides some evidence that stock return volatility in emerging

markets differs from stock return volatility in developed markets. Morck et al.

(2000) find that stock prices are less synchronous in more developed economies by

contrast to less developed economies. Li et al. (2004) find that higher firm-specific

1 Financial statement literate investors are investors who make judicious use of financial statements for

their investment decisions. This concept is distinct from the general notion of financial literacy as in van

Rooij et al. (2011). Domestic investors may well be financially literate in that they understand financial

information when presented to them but they may not be financial statement literate in that they are not

trained to read nor do they attempt to read financial statements.

2 By “drive” here, we mean that the volatility of return revisions is primarily a function of cash flow or

discount rate news volatility.

3 In short these are not two independent hypotheses. If we find that foreign investors are more likely

to revise their return expectations to cash flow news that necessarily means that domestic investors are

more likely to revise their return expectations to discount rate news and vice versa. This follows because

of the tautological relationship between revisions to returns, cash flow news and discount rate news. See

Vuolteenaho (2002) and the discussion further below.

4 Most empirical studies – e.g., Campbell and Vuolteenaho (2004a), Callen and Segal (2004), Callen et al.

(2005), Callen et al. (2006), Hecht and Vuolteenaho (2006), Callen et al. (2010) among others – find that

discount rate news and cash flow news are negatively correlated. The reason for the negative correlation is

provided further below.

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