Earnings Announcements and Systematic Risk

Firms scheduled to report earnings earn an annualized abnormal return of 9.9%. We propose a risk-based explanation for this phenomenon, in which investors use announcements to revise their expectations for non-announcing …rms, but can only do so imperfectly. Consequently, the covariance between …rm-speci…c and market cash-‡ow news spikes around announcements, making announcers especially risky. Consistent with our hypothesis, announcer returns forecast aggregate earnings. The announcement premium is persistent across stocks, and early (late) announcers earn higher (lower) returns. Non-announcers respond to announcements in a manner consistent with our model, both across time and cross-sectionally. Finally, exposure to announcement risk is priced. JEL Classi…cation: G12 Keywords: Risk Premia, Earnings, Announcements Pavel Savor is at the Fox School of Business at Temple University. Mungo Wilson is at the Said Business School and the Oxford-Man Institute at Oxford University. We thank Cam Harvey (the editor), an anonymous associate editor, two anonymous referees, John Campbell, Robert de Courcy-Hughes, Lubos Pastor, Stephanie Sikes, Rob Stambaugh, Laura Starks, Amir Yaron, and seminar participants at Acadian Asset Management, AHL, American Finance Association annual meeting, Arrowstreet Capital, Auckland Finance Meeting, Bristol University, Carnegie Mellon University (Tepper), the European Summer Symposium in Financial Markets, Georgia Institute of Technology (Scheller), Kepos Capital, NBER Summer Institute Asset Pricing Workshop, Quantitative Management Associates, PDT Partners, SAC Capital Advisors, UCLA (Anderson), the University of North Carolina (Kenan-Flagler), and the University of Pennsylvania (Wharton) for their valuable comments. Savor gratefully acknowledges …nancial support from the George Weiss Center for International Financial Research at the Wharton School. Firms on average experience stock price increases during periods when they are scheduled to report earnings. This earnings announcement premium was …rst discovered by Beaver (1968) and was subsequently documented by Chari, Jagannathan, and Ofer (1988), Ball and Kothari (1991), Cohen, Dey, Lys, and Sunder (2007), and Frazzini and Lamont (2007). Kalay and Loewenstein (1985) obtain the same …nding for …rms announcing dividends. None of these papers …nd that the high excess returns around announcement days can be explained in the conventional manner by increases in systematic risk. In this paper, we propose and test a risk-based explanation for the announcement premium that combines two ideas. First, earnings reports provide valuable information not only about the prospects of the issuing …rms but also about those of their peers and more generally the entire economy. However, investors face a signal extraction problem: they only directly observe total …rm earnings and must infer the news relevant to expected aggregate cash ‡ows, the common component of an announcing …rm’s earnings news.i This spillover from the cash-‡ow news of an individual announcer to the wider market creates a high conditional covariance between …rmand market-level cash-‡ow news, generating a high risk premium for the announcing …rm. Although non-announcing stocks also respond to the news in announcements, they should respond less, since investors learn less about these …rms. Second, realized …rm-level returns contain a component unrelated to expected future cash ‡ows: discount-rate news (Campbell and Shiller (1988)). If discount-rate news is more highly correlated across …rms (Cohen, Polk, and Vuolteenaho (2003)), market betas will mainly re‡ect covariance between …rmand market-level discount-rate news (Campbell and Mei (1993)). In consequence, an announcing …rm can have higher fundamental risk than the market, even after controlling for its market beta.ii In other words, although a …rm’s market beta may rise on the day it announces earnings, the increase in its expected return will be larger than can be explained just by its higher beta. This means that we expect a positive announcement return even if the actual earnings surprise is zero.iii Under our hypothesis, the market return will be a poorer predictor of future aggregate