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Adverse selection costs and the dealers' bid-ask spread around earnings announcements: Differential information and signal quality
Abstract
This study examines the behavior of the bid-ask spread and the adverse selection cost component surrounding second quarter earnings and subsequent dividend announcements of Over-The-Counter firms. It examines the efficiency of such announcements in reducing the relative information asymmetry in a firm's environment, given that the adverse selection cost component of the spread is positively associated with a dealer's perception of the relative level of information asymmetry. Specifically, the study analyzes the relationship between the adverse selection cost component of the spread and (i) the quality of earnings, and (ii) the pre-disclosure information environment of the firm. Initial results indicate a decrease in the dealers' perception of the relative information asymmetry in the pre-announcement period possibly due to the "abstain or disclose" rule of the Security Exchange Commission. Further, there is evidence of a decrease in the adverse selection costs in the post-announcement period as new information gets impounded by the market. The study demonstrates that the market maker perceives an increase in the level of informed trading in the event period of the low quality of earnings firms versus high quality of earnings firms. Further, contrary to expectations based on Miller and Rock (1985), there is evidence to indicate that subsequent dividend signals are not efficient in reducing the perceived levels of information asymmetry for earnings signals that are noisy. The cross-sectional results for the differential information portfolios are sensitive to the choice of the quality of earnings measure. Adverse selection costs demonstrate increases surrounding the dividend signal of high differential firms with no significant change surrounding the earnings announcement. There is also evidence of reduced adverse selection costs associated with the earnings signal of low and medium differential firms with weak evidence of increases for the dividend signal. A positive relationship between adverse selection costs and the timing of earnings reports and unexpected earnings was also indicated. These findings suggest that earnings announcements are useful in reducing the information asymmetry between investors, conditional on the quality of the signal and the pre-disclosure information environment of the firm.
Subject Area
Accounting|Finance
Recommended Citation
Chipalkatti, Niranjan H, "Adverse selection costs and the dealers' bid-ask spread around earnings announcements: Differential information and signal quality" (1993). Doctoral Dissertations Available from Proquest. AAI9329582.
https://scholarworks.umass.edu/dissertations/AAI9329582