sentiment - Do Stock Market Investors Understand the Risk...

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Do Stock Market Investors Understand the Risk Sentiment of Corporate Annual Reports? Feng Li Stephen M. Ross School of Business, University of Michigan 701 Tappan St., Ann Arbor, MI 48109 Phone: (734)936-2771 Email: Feng@umich.edu First Draft: August 2005 This Draft: April 21, 2006 This paper was previously titled “The implications of annual report’s risk sentiment for future earnings and stock returns”. I acknowledge the ±nancial support of the Harry Jones Endowment for Research on Earnings Quality at the Ross School of Business, University of Michigan. I thank Jason Chen, Shijun Cheng, Patty Dechow, Ilia Dichev, Michelle Hanlon, Yu Huang, Gene Imho², Roby Lehavy, Michal Matejka, Venky Nagar, Richard Sloan, Suraj Srinivasan, and the workshop participants at the University of Michigan for their comments. All errors remain mine.
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Abstract I test the stock market efficiency with respect to the information in the texts of an- nual reports. More speciFcally, I examine the implications of corporate annual reports’ risk sentiment for future earnings and stock returns. I measure the risk sentiment of annual reports by counting the frequency of words related to risk or uncertainty in the 10-K Flings. I Fnd that an increase in risk sentiment is associated with lower future earnings: ±irms with a larger increase in risk sentiment have more negative earnings changes in the next year. Risk sentiment of annual reports can predict future returns in a cross-sectional setting: ±irms with a large increase in risk sentiment experience signiFcantly negative returns relative to those Frms with little increase in risk senti- ment in the twelve months after the annual report Fling date. A hedge portfolio based on buying Frms with a minor increase in risk sentiment of annual reports and shorting Frms with a large increase in risk sentiment generates an annual Alpha of more than 10% measured using the four-factor model including the ±ama-±rench three factors and the momentum factor. 1
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1 Introduction This paper tests the efficiency of stock market with respect to the information contained in the texts of publicly available documents. In particular, I study the implications of corporate annual report’s risk sentiment (i.e., its emphasis on risk and uncertainty) for future earnings and stock returns. There are a large number of studies in Fnance and accounting that document empirical regularities on the association between public information and future stock returns. The information set examined includes Fnancial or market variables such as size, book-to-market ratio, accruals, corporate investment, past stock returns, and analyst forecast, among others. Other studies explore future returns following Frm events, such as earnings announcement, IPO, SEO, and merger and acquisitions.
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sentiment - Do Stock Market Investors Understand the Risk...

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