Knowledge that Transforms

This paper examines three possible specification problems with the research on information content of earnings disclosure. The first deals with the extent to which contemporaneous prediction errors are good surrogates for revisions of future earnings expectations and, hence, distributions of cash flows. This problem is elucidated by evaluating analysts' revisions of future earnings expectations as “relevant omitted variables.” The results show that the quality of such surrogation is high in the first quarter but low in the second. The second problem concerns the degree to which analysts' earnings forecasts are good surrogates for the market's own earnings expectations. Unbiasedness and orthogonality are the two properties examined. Although analysts' forecasts satisfy the unbiasedness property, the necessary condition of orthogonality is not satisfied. Hence, analysts' earnings forecasts are not Muthian rational expectations (i.e., they are not good surrogates for market forecasts). Consequently, the explanatory power of known empirical results is likely to be understated. The third specification issue is the significance of the self‐selection bias resulting from endogenous partitioning of samples into, say, good‐ and bad‐news portfolios. The Heckman‐Lee method of correcting for this type of selection (truncation) bias is applied. The results show significant self‐selection bias in both quarters but more so in the first than in the second quarter. Although applying the correction for this sample did not alter the general inferences, it did alter the marginal contribution of each explanatory variable and the explanatory power of the models. The results indicate that the information news about quarterly earnings is not homogeneous across different quarters in a fiscal period. The possibility that a “quarter effect” exists needs further investigation. Résumé. L'auteur se penche sur trois problèmes de spécification possibles en ce qui a trait à la recherche sur le contenu informatif des bénéfices publiés. Le premier de ces problèmes porte sur la mesure dans laquelle les erreurs prévisionnelles actuelles sont des substituts efficaces aux ajustements des bénéfices éventuels prévus et, partant, aux distributions de flux monétaires. On élucide ce problème grâce à l'évaluation des ajustements des bénéfices éventuels prévus effectués par les analystes, à titre de « variables pertinentes omises ». Les résultats de l'étude montrent que la qualité de cette substitution est élevée pour le premier trimestre mais faible pour le second. Le deuxième problème a trait à la mesure dans laquelle les prévisions de bénéfices des analystes sont des substituts efficaces aux prévisions de bénéfices au marché. L'auteur se demande si les prévisions des analystes sont non biaisées et orthogonales. Bien qu'elles se révèlent en effet non biaisées, elles ne respectent pas le critère d'orthogonalité. Les prévisions de bénéfices des analystes ne sont donc pas des prévisions rationnelles de Muthian (c'est‐à‐dire qu'elles ne sont pas des substituts efficaces aux prévisions du marché). On peut donc penser que le pouvoir explicatif des résultats empiriques connus est sous‐estimé. Le troisième problème de spécification est celui de la signification de la distorsion d'autosélection résultant du découpage endogène des échantillons, par exemple sous forme de portefeuilles dont les comptes rendus sont favorables ou défavorables. L'auteur applique la méthode de correction Heckman‐Lee prévue pour ce genre de distorsion de sélection (tronquée). Les résultats révèlent une importante distorsion d'autosélection pour les deux trimestres, plus marquée toutefois dans le premier que dans le second. Bien que l'application de la méthode de correction à cet échantillon n'ait pas modifié les inférences générales, elle a modifié la valeur explicative marginale de chaque variable et le pouvoir explicatif des modèles. Les résultats obtenus indiquent que l'information relative aux bénéfices trimestriels n'est pas homogène dans les différents trimestres d'un exercise financier. L'existence possible d'un « effet trimestre » doit faire l'objet de recherches plus approfondies.

This paper reviews and critiques the positive accounting literature following publication of Watts and Zimmerman (1978, 1979). The 1978 paper helped generate the positive accounting literature which offers an explanation of accounting practice, suggests the importance of contracting costs, and has led to the discovery of some previously unknown empirical regularities. The 1979 paper produced a methodological debate that has not been very productive. This paper attempts to remove some common misconceptions about methodology that surfaced in the debate. It also suggests ways to improve positive research in accounting choice. The most important of these improvements is tighter links between the theory and the empirical tests. A second suggested improvement is the development of models that recognize the endogeneity among the variables in the regressions. A third improvement is reduction in measurement errors in both the dependent and independent variables in the regressions.

Changes in stock prices have substantial explanatory power for U.S. investment, especially for long-term samples, and even in the presence of cash flow variables. The stock market dramatically outperforms a standard q-variable because the market-equity component of this variable is only a rough proxy for stock market value. Although the stock market did not predict accurately after the crash of October 1987, the errors were not statistically significant. Parallel relationships for Canada raise the puzzle that Canadian investment appears to react more to the U.S. stock market than to the Canadian market.

Stambaugh, and especially to Robert Merton for comments on a previous draft. This paper is part of NBER's research program in Financial Markets and Monetary Economics. Any opinions expressed are those of the author not those

This article analyzes the behavior of stock return volatility using daily data from 1885 through 1988. The October 1987 stock market crash was unusual in many ways. October 19 was the largest percentage change in market value in over 29,000 days. Stock volatility jumped dramatically during and after the crash. Nevertheless, it returned to lower, more normal levels more quickly than past experience predicted. I use data on implied volatilities from call option prices and estimates of volatility from futures contracts on stock indexes to confirm this result.

We investigate product-market competition when managers maximize shareholder value rather than their expected discounted value of profits. If shareholders are imperfectly informed about future profitability, shareholder-value maximization can lead to either more or less aggressive product-market strategies. Lower rivals’ profits lead investors to believe that the firm’s costs are low relative to those of its rivals and that the industry’s prospects are poor. If the former (latter) inference dominates, each firm tries to lower (raise) its rivals’ profits to increase its own stock price. We also consider implications for corporate financial structure.

This article generalizes the Cox, Ross, and Rubinstein (1979) binomial option-pricing model, and establishes a convergence from discrete-time multivariate multinomial models to continuous-time multidimensional diffusion models for contingent claims prices. The key to the approach is to approximate the N-dimensional diffusion price process by a sequence of N-variate, (N+1)-nomial processes. It is shown that contingent claims prices and dynamic replicating portfolio strategies derived from the discrete time models converge to their corresponding continuous-time limits.

We find that conditional means and variances of consumption growth vary through time, and this variation appears to be associated with the business cycle. A pricing model with fluctuating means and variances of consumption growth provides implications about conditional moments of returns for both short and long investment horizons, and these implications are explored empirically. The U-shaped pattern of first-order autocorrelations of returns, as well as business cycle patterns in the price of risk, appears to be consistent with the model, but our exploration suggests that other implications about conditional return moments are at odds with the data.