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Earnings Announcement Premia and the Limits to Arbitrage | Overview

Last Updated on 10 February, 2024 by Rejaul Karim

In the intricate landscape of financial markets, the paper “Earnings Announcement Premia and the Limits to Arbitrage” unveils a comprehensive exploration authored by Daniel A. Cohen, Aiyesha Dey, Thomas Z. Lys, and Shyam V. Sunder. Spanning 50 pages and posted in 2005, this research scrutinizes the persistence of earnings announcement-day premia across diverse disclosure environments.

Notably, the premia endure beyond the scope of previous studies, revealing intriguing patterns that transcend the boundaries of sample periods. The authors delve into the risk-return dynamics, demonstrating that the presence of announcing firms in a well-diversified portfolio contributes to a more favorable risk-return trade-off.

Furthermore, the study sheds light on the role of preannouncements in curbing announcement risk and underscores the nuanced interplay between premia and the inherent limits to arbitrage in financial markets.

Abstract Of Paper

We document that earnings announcement-day premia persist beyond the sample period of earlier studies, over different disclosure environments and remain robust to the refinement of using the expected announcement day rather than the actual announcement day. A portfolio of announcing firms yields returns in excess of the corresponding risk. Excluding announcers from a well-diversified portfolio, while reducing the standard deviation of that portfolio, also reduces its Sharpe ratio, indicating that this strategy results in a less favorable risk-return trade-off. Finally, we provide evidence that the premia are dramatically reduced when the announcement risk is reduced through preannouncements. In addition, we document that the continued presence of this premia is likely to result from limits to arbitrage. These findings are consistent with the view that the announcement period returns are likely to represent compensation for announcement risk.

Original paper – Download PDF

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Author

Daniel A. Cohen
Vanderbilt University – Owen Graduate School of Management

Aiyesha Dey
Harvard Business School

Thomas Z. Lys
Northwestern University – Kellogg School of Management

Shyam V. Sunder
University of Arizona – Department of Accounting

Conclusion

In conclusion, the study reveals the enduring nature of earnings announcement-day premia, extending across diverse disclosure environments and remaining resilient to refinements in timing methodologies.

Significantly, a portfolio exclusive to announcing firms demonstrates risk-adjusted returns, highlighting a persistent market anomaly. Interestingly, attempts to mitigate risk through diversification, while reducing portfolio volatility, compromise the risk-return trade-off.

The introduction of preannouncements notably diminishes the premia, emphasizing the impact of announcement risk. These findings strongly suggest that the persistence of these premia can be attributed to limits to arbitrage, underscoring the intricate dynamics of the market and the compensation required for navigating the inherent risks associated with earnings announcements.

Related Reading:

The Earnings Announcement Premium Around the Globe

The January Seasonality and the Performance of Country-Level Value and Momentum Strategies

FAQ

Q1: What is the main focus of the paper “Earnings Announcement Premia and the Limits to Arbitrage,” and what does it reveal about earnings announcement-day premia?

The paper focuses on examining the persistence of earnings announcement-day premia beyond previous study periods and across diverse disclosure environments. It reveals that these premia endure over different contexts and remain robust even when refining the timing methodology to use the expected announcement day. The study sheds light on the risk-return dynamics associated with announcing firms and the nuanced interplay of premia and the limits to arbitrage in financial markets.

Q2: How does the presence of announcing firms in a well-diversified portfolio impact the risk-return trade-off, and what does the study suggest about attempts to mitigate risk through diversification?

The study demonstrates that the presence of announcing firms in a well-diversified portfolio contributes to a more favorable risk-return trade-off, as these firms exhibit risk-adjusted returns. Interestingly, attempts to mitigate risk through diversification, while reducing portfolio volatility, compromise the risk-return trade-off. This implies that the inclusion of announcing firms plays a crucial role in achieving a favorable risk-return balance in a diversified portfolio.

Q3: What role do preannouncements play in the context of earnings announcement-day premia, and how do they impact announcement risk?

The study highlights that the introduction of preannouncements significantly diminishes earnings announcement-day premia. This suggests that preannouncements play a crucial role in reducing announcement risk. The findings emphasize the importance of considering the timing and information disclosure dynamics surrounding earnings announcements when analyzing the persistence of premia in financial markets.

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