Differential information environment and the magnitude of capital market responses to earnings announcements

This study documents an inverse relation between the magnitude of capital market responses to earnings announcements and the precision of predisclosure information through observable characteristics of financial analysts\u27 earnings forecasts. In addition, we provide some evidence that analysts\u27 information acquisition activities respond to the information needs of their main customers (institutional investors) who are mainly interested in large firms. We propose that some characteristics of analysts\u27 earnings forecasts capture the differential predisclosure information. Analysts are modeled as Bayesian forecasters who provide the mean value of their posterior distribution for the liquidating dividend of a risky asset as their earnings forecasts. Investors in the capital market are assumed to update their beliefs by using analysts\u27 earnings forecasts. Price changes in the model are represented by the belief revision of investors. The model predicts a non-monotonic (positive and negative) relation between the divergence in analysts\u27 earnings forecasts (DAF) and the conditional variance of price changes (VPC) around earnings announcement for a given level of the variance of analysts\u27 consensus forecast errors (VFE). Test results show that the relation between DAF and VPC is weakly positive for High Private Group Firms (firms for which analysts seek and process private information more than public information) and it is weakly negative for Low Private Group Firms (firms for which analysts seek and process private information less than public information). The model also predicts an inverse relation between the predisclosure information or the investors\u27 total signal precision (TSP) before the earnings announcement and VPC. Test results are consistent with this prediction. We find that High Private Group Firms are larger size firms, have more analysts\u27 following, less market responses to earnings announcements, and higher levels of predisclosure information. TSP and DAF are high and VFE is small for these firms