Essays on financial accounting information, return predictability, and default risk : a thesis presented in fulfilment of the requirements for the degree of Doctor of Philosophy in Finance at Massey University, Albany, New Zealand
There is a growing realization of the importance of financial and accounting information on financial markets, and this is thus very much an area of focus for academics, practitioners, and regulators. This thesis consists of three essays on financial accounting information, return predictability, and default risk.
The first essay considers the impact of inconsistent financial accounting information on the cross-section of stock returns. This essay uses earnings quality and firm characteristics to capture information signals about the firm value and measure information inconsistency as the variation across the information of the same company. The findings show that returns of information-consistent firms predict the returns of information-inconsistent firms in both equal- and value-weighted portfolios. However, such predictability varies over time due to liquidity funding and investor attention. This first essay thus contributes to the growing literature documenting the cross-section of stock return predictability as a result of the varying speed of information incorporation across stocks.
The second essay examines whether the differences in accounting information between the pairs of stocks affect cross-asset return predictability. This essay uses a comprehensive set of accounting variables and market environments to capture the degree of information reflection. The results show that accounting variables such as abnormal accruals, earnings smoothness, book-to-market, firm age, leverage, abnormal capital investment, and investment growth, among others, explain the variation in predictability across pairing stocks. The cross-asset predictability varies over time and is associated with liquidity funding and market sentiment. A simple trading strategy based on our findings yields a higher mean return, lower standard deviation, and higher Sharpe ratio compared to the buy-and-hold strategy.
The final essay investigates the impact of risk aversion on default risk. While a large body of research documents various firm characteristics and market conditions that drive corporate default, whether risk aversion matters for default risk remains under-investigated. This could be attributed to endogeneity concerns, such as that the investor risk aversion is not an exogenous variable or the presence of omitted variables that drive the default risk and the simultaneity bias between the default risk and the risk aversion. To address the endogeneity challenge, we use the largest mega-terrorist event, the 9/11 terrorist attacks, as an exogenous shock to investor’s risk aversion; the empirical evidence shows a significant increase in default risks at both market and firm levels following the 9/11 attacks. Terrorism causes an increase in market-wide default risk for firms located in the attacked states, as well as for those located in the non-affected states. The findings are consistent with the strand of literature suggesting that, following terrorist attacks, investors become more risk-averse and demand a higher premium for their investment, leading to increased default risk.