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Journal ArticleDOI

Transparency, Price Informativeness, and Stock Return Synchronicity: Theory and Evidence

01 Oct 2010-Journal of Financial and Quantitative Analysis (Cambridge University Press)-Vol. 45, Iss: 5, pp 1189-1220

AbstractThis paper argues that, contrary to the conventional wisdom, stock return synchronicity (or R2) can increase when transparency improves. In a simple model, we show that, in more transparent environments, stock prices should be more informative about future events. Consequently, when the events actually happen in the future, there should be less “surprise” (i.e., less new information is impounded into the stock price). Thus a more informative stock price today means higher return synchronicity in the future. We find empirical support for our theoretical predictions in 3 settings: namely, firm age, seasoned equity offerings (SEOs), and listing of American Depositary Receipts (ADRs).

Topics: Stock exchange (61%), Restricted stock (61%), Stock market bubble (59%), Market maker (59%), Non-qualified stock option (58%)

Summary (3 min read)

Introduction

  • This paper argues that, contrary to the conventional wisdom, stock return synchronicity (or R2) can increase when transparency improves.
  • The other is time-invariant, such as managerial quality.
  • Listing events is the main focus of their empirical exercise and the authors find strong support for it in the data.
  • First, the authors address the literature on transparency, informativeness of stock prices, and stock return synchronicity by arguing that a more transparent firm can have a higher return synchronicity, contrary to the conventional wisdom.

Theory

  • 6 Lang and Lundholm (1996) examine the relation between firms’ disclosure policies, analyst following, and the accuracy of analysts’ forecasts.
  • Here, captures market factors that are observed by all; tf t,1θ and t,2θ are firm-specific shocks.
  • Outsiders only observe t,1θ , whereas insiders observe both t,1θ and t,2θ .
  • The authors now depart from Jin and Myers (2006) by assuming that there is a change in the firm’s disclosure policy and the firm becomes more transparent.

A.1. Lumpy (One-Time) Information Disclosure

  • During SEOs or ADR listings, the firm becomes more transparent in the sense that a big chunk of information comes out that otherwise would have come out later, or perhaps not at all.
  • For simplicity of exposition, the authors make the extreme assumption that the information revealed at disclosure affects only the cash flow shock one period later, i.e. it is relevant for events that occur one period later only.
  • 0t Proposition 1(a). (i) The proportion of the realized variation in period (i.e. between and0t 0t 10 +t ) explained by market factors is higher for a firm that experience an improvement in disclosure at than one that does not.
  • The return synchronicity will increase subsequently – there is less information content to later announcements since part of the information is already impounded in the stock price.

A.2. Regular Early Disclosure of Information

  • To formalize this notion of transparency, the authors assume that at the beginning of every period, there is some disclosure that reduces the variance of the cash flow shock revealed to the public at the end of the period.
  • The result that the return synchronicity actually increases in this case may be somewhat surprising.
  • The reason is that the information revealed at the end of the period regarding the cash flow innovation still one period later is discounted relative to the information revealed at the beginning of the period, since the former is relevant for a more distant cash flow.
  • Moreover, define the information set Proof: . 8 West (1988) considers a very general framework that has a similar implication.
  • Alternatively and as the authors show in this section, it can also be associated with either early disclosure of time-varying firm specific information, or disclosure of time-invariant information about firm characteristics, which may cause return synchronicity to increase.

IV. Empirical Evidence

  • This section provides evidence consistent with the theory outlined above, in three different settings.
  • Consistent with their univariate analysis, firm age is associated with significantly higher R2 (and thus lower LSSE), at the 1% levels, reflecting learning about the time-invariant information.
  • Therefore, the authors follow Roll (1988), Piotroski and Roulstone (2004), Durnev, Morck, Yeung, and Zarowin (2003), and Durnev, Morck, and Yeung (2004) by adding industry returns in the standard market model regression.
  • Inclusion of additional risk factors do not change the age effect on return synchronicity (columns (3) and (4) of Panel A in Table 2).
  • One such setting is seasoned equity offerings (SEOs).

B.1. Empirical Specification

  • To capture the inter-temporal response of R2 around SEOs, the authors pursue a specification that imposes very little structure on the response dynamics.
  • Thus earnings smoothing would bias against their results, by raising R2 prior to ADR or SEO events.
  • Hypothesis 2 derives from the second part of Proposition (1a).16 Hypothesis 1.
  • That is, SEOs are not randomly assigned; there might be unobserved firm characteristics that simultaneously affect the SEO decisions and return synchronicity.
  • Second, the authors include firm-fixed effects in all their estimations.

B.2. Results

  • Compared to non-SEO firm-years, SEO firm-years differ in almost all firm characteristics, suggesting that firm characteristics need to be controlled for in their later analysis.
  • The impacts of other firm control variables are similar to those in Table 2.
  • Then according to their Proposition 1(b) and Proposition 2, the return synchronicity may continue to be higher.
  • Consistent with their model’s predictions, ADRs are associated with a persistent drop in firm specific information in stock prices (i.e., higher R2) in the years after the listings.
  • 21 Specifically, the authors define countries with a score above 20 We note that some firms may cross list in countries other than the U.S.the authors.

V. Conclusion

  • Existing literature has taken the perspective that if a firm’s information environment causes stock prices to reflect more firm-specific information, market factors should explain a smaller proportion of the variation in stock returns.
  • The authors empirical evidence is drawn from three different settings.
  • In particular, return synchronicity decreases prior to these events, and increases subsequently.
  • Overall, the authors make two contributions to the literature.
  • First, by showing both theoretically and empirically that stock return synchronicity can increase with improved firm transparency, the authors highlight the importance of understanding the nature of information discovery and the dynamics of response of stock return synchronicity to changes in information environment.

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Stock Return Synchronicity and the Informativeness of
Stock Prices: Theory and Evidence
1
Sudipto Dasgupta
Jie Gan
+
Ning Gao
#
JEL Classification Code: G14, G39
Keywords: Stock return synchronicity; R
2
; Firm-specific return variation; Informativeness
of stock prices; Transparency; Seasoned equity offering; Cross listing.
1
We thank Utpal Bhattacharya, Michael Brennan, Kalok Chan, Craig Doidge, Art Durnev, Robert Engle, Li Jin,
Ernst Maug, Stewart Myers, Wei Jiang, Anil Makhija, Bill Megginson, Randall Morck, Mark Seasholes, Jeremy
Stein, Martin Walker, Bernard Yeung and participants at the 2006 Financial Intermediation Research Society
Conference and the 2006 WFA Conference for helpful comments and discussions. We are grateful to Hendrik
Bessembinder (the editor) and two anonymous referees for their comments and suggestions which greatly improved
the paper.
Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong
Kong. Email: dasgupta@ust.hk.
+
Department of Finance, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong
Kong. Email: jgan@ust.hk.
#
The Manchester Accounting and Finance Group, Manchester Business School, the University of Manchester,
Booth Street West, Manchester, M15 6PB, United Kingdom. Email: ning.gao@mbs.ac.uk.
1

Stock Return Synchronicity and Informativeness of Stock
Prices: Theory and Evidence
Abstract
This paper argues that, contrary to the conventional wisdom, stock return synchronicity (or R
2
) can
increase when transparency improves. In a simple model, we show that, in more transparent
environments, stock prices should be more informative about future events. Consequently, when the
events actually happen in the future, there should be less “surprise”, i.e., there is less new information
impounded into the stock price. Thus a more informative stock price today means higher return
synchronicity in the future. We find empirical support for our theoretical predictions in three settings,
namely firm age, seasoned equity issues, and listing of ADRs.
JEL Classification Code: G14, G39
Keywords: Stock return synchronicity; R
2
; Firm-specific return variation; Informativeness
of stock prices; Transparency; Seasoned equity offering; Cross listing.
2

I. Introduction
Financial economists generally agree that in efficient markets, stock prices change to
reflect available information – either firm-specific or market-wide. Recent literature has
addressed the question of how a firm’s information environment (disclosure policy, analyst
following) or its institutional environment (property rights protection, quality of government,
legal origin) can affect the relative importance of firm-specific as opposed to market wide factors
(Jin and Myers (2006), Piotroski and Roulstone (2003), Chan and Hameed (2006), and Morck,
Yeung, and Yu (2000)). This literature has taken the perspective that if the firm’s environment
causes stock prices to aggregate more firm-specific information, market factors should explain a
smaller proportion of the variation in stock returns. In other words, the stock return synchronicity
or R
2
from a standard market model regression should be lower.
This perspective, while intuitive, is at odds with another equally intuitive implication of
market efficiency. In efficient markets, stock prices respond only to announcements that are not
already anticipated by the market. When the information environment surrounding a firm
improves and more firm-specific information is available, market participants are also able to
improve their predictions about the occurrence of future firm-specific events. As a result,
prevailing stock prices are likely to already “factor in” the likelihood of occurrence of these
events. When the events actually happen in the future, the market will not react to such news,
since there is little “surprise”. In other words, more informative stock prices today should be
associated with less firm-specific variation in stock prices in the future. Therefore, the return
synchronicity should be higher.
In this paper, we present a simple model to illustrate the point that a more transparent
information environment can lead to higher, rather than lower, stock return synchronicity. This is
3

because, for a more transparent firm, there is already more information available to market
participants, reducing the “surprise” from future announcements. In our model, we distinguish
between two types of firm-specific information. One pertains to time-varying firm
characteristics, reflecting the current state of the firm, such as next quarter’s earnings. The other
is time-invariant, such as managerial quality.
2
Stock return synchronicity can increase
subsequent to an improvement in transparency through disclosure of both types of information.
First, greater transparency can lead to early disclosure of time-variant information. This can
happen around major events such as seasoned equity issues (SEOs) or cross-listings, during
which a big chunk of information about future events is revealed. Thus when future events
actually happen, there is less “surprise” and hence less additional information to be incorporated
in the stock price, resulting in a higher return synchronicity.
3
While the positive effect of greater
transparency on return synchronicity is most significant in the case of a one-time lumpy
disclosure, we show that it also holds in the more general setting with regular, early disclosure of
information. In particular, we show that in a dynamic setting, if at the beginning of every period,
outsiders get to know (one period ahead of time) some of the information that otherwise would
come out at the end of the period, the return synchronicity is actually higher.
The second channel through which greater transparency increases stock return
synchronicity is due to learning about time-invariant firm-specific characteristics, such as
managerial quality. In particular, better disclosure allows market participants to learn about time-
invariant firm fundamentals with greater precision (e.g., in the extreme case where the
2
Strictly speaking all firm characteristics are time varying in the very long run. Here we refer to those
characteristics that do not change frequently or do not change much over time (so that they do not affect valuation
significantly) as “time-invariant.”
3
Shiller (1981) notes theoretically that if dividend news arrives in a lumpy and infrequent way, stock price volatility
becomes lower. If much of the dividend news reflects firm specific information, one would also expect return
synchronicity to become higher.
4

fundaments are completely known, there is no new learning). Therefore, with more disclosure,
the priors about these fundamentals will be revised less drastically as new information comes in.
As a result, there will be less firm-specific variation in stock prices, i.e., the return synchronicity
will be higher.
We present three pieces of empirical evidence consistent with our model’s predictions.
We first provide evidence of learning about time-invariant firm-specific information. The idea is
that, as a firm becomes older, the market learns more about its time-invariant characteristics, e.g.,
the firm’s intrinsic quality. Therefore, return synchronicity should be higher for older firms,
since more of the (time-invariant) firm-specific information is already reflected in the stock
price. This prediction is strongly supported by the data.
Second and third, we exploit the fact that the effect of greater transparency on stock
return synchronicity is likely to be especially clear when the disclosure is “lumpy”, in the sense
that the market receives a big chunk of information relevant for future cash flows. Therefore, we
focus on seasoned equity offerings (SEOs) and cross-listings in the U.S.
4
It is well known that
both events are associated with significant amounts of information disclosure and market
scrutiny (see, e.g., Almazan et al. (2002) for SEO, and Lang et al. (2003) for ADR listings). Our
model suggests a dynamic response of return synchronicity to an improvement in the information
environment. At the time when new information is disclosed and impounded into stock prices,
the firm-specific return variation will increase, as suggested by conventional wisdom. However,
since a big chunk of relevant information is already reflected in stock prices, we would expect
the firm-specific return variation of SEO and cross-listed firms to be subsequently lower. This
dynamic response of the firm-specific return variation around seasoned equity issues and cross-
4
While firms can list their shares in the U.S. exchanges either through ADRs or through direct listings, the literature
sometimes uses the two terms “cross listings” and “ADR listings” interchangeably (see, e.g., Lang, Lins, and Miller
(2003)). In the rest of this paper, we follow this convention, except when we discuss our sample.
5

Figures (7)
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Abstract: This paper identities five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors. related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates. the bond-market factors capture the common variation in bond returns. Most important. the five factors seem to explain average returns on stocks and bonds.

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Frequently Asked Questions (1)
Q1. What are the contributions in "Stock return synchronicity and the informativeness of stock prices: theory and evidence" ?

This paper argues that, contrary to the conventional wisdom, stock return synchronicity ( or R ) can increase when transparency improves. In a simple model, the authors show that, in more transparent environments, stock prices should be more informative about future events.