Analyst Forecasts : The Roles of Reputational Ranking and Trading Commissions

This paper examines how reputational ranking and trading commission incentives influence the forecasting behavior of sell-side analysts. I develop a model in which two analysts simultaneously forecast a company’s earnings. Each analyst attempts to maximize his compensation, which is a linear combination of his trading commissions and his expected reputational value in the labor market. My main predictions from this model are as follows: (i) Reputational concerns alone do not provide analysts with suffi cient incentive for honest reporting. Indeed, a reputational payoff structure in which the reward for being the only good analyst is suffi ciently larger than the penalty for being the only bad analyst makes the incentive problem even worse. (ii) Trading commissions alone also provide perverse incentive. While, with single analyst, there is no honest reporting, with multiple analysts, the information content of analyst forecasts go up because of the analysts’desire to coordinate. (iii) Trading commissions, together with reputational concerns, provide better incentive for honest reporting than reputational concerns or trading commissions alone. ∗Department of Accounting, University of Minnesota, [email protected]. I am deeply indebted to my advisor, Chandra Kanodia, for his guidance, encouragement and insights. I am also extremely grateful to Frank Gigler for his many helpful comments and insights. I also appreciate Ichiro Obara for his helpful comments and suggestions. I also thank Aiyesha Dey, Mingcherng Dreng, Zhaoyang Gu, Tom Issaevitch, Xu Jiang, Mo Khan, Jae Bum Kim, Pervin Shroff, Dushyant Vyas and participants at the workshop at the University of Minnesota for their helpful comments and suggestions. All errors are mine.