Information quality, systematic risk and the cost of capital. Working paper

Most models that examine the relationship between information quality and cost of capital do so in a single firm setting, and predict that the relationship is negative. Given the lack of consistent empirical support for this prediction, we reconsider this relationship in a setup where covariance risk, and not variance risk, determines the cost of capital. We allow investors to independently learn about systematic risk-factors and firm-specific betas. We show that an increase in information quality of either type (systematic or firm-specific) has two effects on a firm’s expected returns: (i) a “beta ” effect which decreases expected returns when beta is positive, but increases expected returns when beta is negative, and (ii) a “convexity ” effect which generally increases the expected returns. We test these predictions using proxies for systematic information quality based on the VIX and firm-specific information quality based on analyst forecasts and accruals quality, and find evidence consistent with our predictions