Earnings Volatility, Cash Flow Volatility, and Informed Trading



    1. Olin Business School, Washington University in St. Louis. This paper is based on my doctoral dissertation at the University of North Carolina at Chapel Hill. I am indebted to my committee members Robert Bushman, Wayne Landsman, Mark Lang, and Gunter Strobl, and especially to my dissertation chairman, Jeffery Abarbanell. I also appreciate helpful comments from Phil Berger (editor), an anonymous referee, Donal Byard, Hemang Desai, Scott Dyreng, Richard Frankel, John Hand, Doug Hanna, Chris Petrovits, Jana Raedy, Kartik Raman, Steve Stubben, Anjan Thakor, Kumar Venkataraman, S. Viswanathan, Wendy Wilson, and workshop participants at the 18th Annual FEA Conference, Baruch College, Rutgers University, Southern Methodist University, University of North Carolina at Chapel Hill, and Washington University in St. Louis. I am grateful to Joel Hasbrouck and Soeren Hvidkjaer for sharing their data with me.
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I examine whether earnings that are smoother or more volatile than cash flows provide or garble information. Consistent with theories that predict more informed trading when public information is less informative, I find that bid-ask spreads and the probability of informed trading are higher both when earnings are smoother than cash flows and also when earnings are more volatile than cash flows. Additional tests suggest that managers' discretionary choices that lead to smoother or more volatile earnings than cash flows garble information, on average. However, I find that informed trading is attenuated in settings in which theory suggests that discretionary smoothing or volatizing of earnings is likely to be informative.