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PEAD_kimchoi - Underreaction Trading Volume and...

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Underreaction, Trading Volume, and Post-Earnings Announcement Drift * Wonseok Choi [email protected] Department of Economics Harvard University Jung-Wook Kim ** [email protected] School of Business University of Alberta First draft: April, 2001 This draft: November, 2001 ABSTRACT In this paper, we develop a simple model in which trading volume contains information about future stock returns. Specifically, our model explains why high trading volume is observed when a firm announces earnings news and how trading volume can be related to the initial underreaction of the stock price. Our model has a clear testable implication that high abnormal trading volume predicts a stronger drift. We test our model’s implication and find strong evidence for the model in the case of positive news. Weaker evidence is found in the case of negative news. We also discuss possible explanations for the asymmetric informativeness of trading volume. JEL code: G14 Key words: Earnings announcement, Underreaction, Public information, Trading volume, Drift * We especially thank Jeremy Stein, Andrei Shleifer, Rafael LaPorta for their suggestions and guidance. We also thank John Campbell, Randall Morck, Mark Huson, Jason Lee, Aditya Kaul and seminar participants at Harvard University and University of Alberta for helpful suggestions. Wonseok Choi acknowledges a scholarship from KFAS and Harvard-Yenching Institute, and Jung-Wook Kim acknowledges funding from POSCO. ** Corresponding author: 2-32C Business Building, University of Alberta, Edmonton, AB, Canada T6G 2R6. Tel) 780-492-7987 Fax) 780-492-3325. E-mail: [email protected] 1
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1. Introduction Ball and Brown (1968) are the first to find that the abnormal return of firms with positive earnings news continues to drift upward after the earnings announcements and that the opposite is true for firms with negative news. Since then, many researchers have extensively investigated the post-earnings announcement drift. Bernard (1993) writes an excellent survey paper dealing with the underreaction of stock prices to announcements of companies’ earnings. He conjectures that market participants do not recognize the positive autocorrelations in earnings changes but in fact believe that earnings follow a random walk. In this case, investors do not fully reflect the news content of earnings announcements and a subsequent drift can be observed. Recently, there have been several attempts to explain investors' underreaction. 1 Barberis, Shleifer and Vishny (1998, henceforth BSV) provide a formal model to explain underreaction to earnings announcements. 2 Their explanation of underreaction to earnings announcements is related to investors’ conservatism. Conservatism refers to the reluctance of individuals to update their beliefs upon receiving new information (Edwards, 1968). Conservatism fits the underreaction story very well. Investors subject to conservatism might disregard the full information content of an earnings (or some other public) announcement because
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