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Earnings Volatility, Post–Earnings Announcement Drift, and Trading Frictions

Authors

  • SEAN SHUN CAO,

    1. University of Massachusetts Boston College of Management. University of Illinois at Urbana-Champaign. We would like to thank the anonymous referee and Phil Berger (editor) for helpful suggestions. We would also like to thank Paul Beck, Rajib Doogar, Hanna Lee, Mark Peecher, Matthew Stern, Hui Zhou, and seminar participants at the University of Illinois at Urbana-Champaign and the AAA 2010 annual meeting, and especially, Theodore Sougiannis for helpful discussions. Sean Cao is very grateful for research support from the PhD program at the University of Illinois–Champaign. Brenda Priebe rendered excellent professional editing assistance. Residual errors remain our responsibility.
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  • GANAPATHI S. NARAYANAMOORTHY

    1. University of Massachusetts Boston College of Management. University of Illinois at Urbana-Champaign. We would like to thank the anonymous referee and Phil Berger (editor) for helpful suggestions. We would also like to thank Paul Beck, Rajib Doogar, Hanna Lee, Mark Peecher, Matthew Stern, Hui Zhou, and seminar participants at the University of Illinois at Urbana-Champaign and the AAA 2010 annual meeting, and especially, Theodore Sougiannis for helpful discussions. Sean Cao is very grateful for research support from the PhD program at the University of Illinois–Champaign. Brenda Priebe rendered excellent professional editing assistance. Residual errors remain our responsibility.
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ABSTRACT

We find that lower ex ante earnings volatility leads to higher Post–Earnings Announcement Drift (PEAD). PEAD is a function of both the magnitude of an earnings surprise and its persistence. While prior research has largely investigated market reactions to the magnitude of the earnings surprise, in this study we show that the persistence of the earnings surprise is equally important. A unique feature of the anomalous PEAD returns documented here concerns the association between abnormal returns and trading frictions. Besides demonstrating that firms with lower earnings volatility have higher abnormal returns, we also find that lower earnings volatility firms have lower trading frictions. Taken together, these findings imply that higher abnormal returns are associated with lower trading frictions. We exploit this implication to empirically demonstrate that PEAD returns due to earnings volatility are not concentrated in the firms with the largest trading frictions, which is in contrast to the findings in prior anomaly studies.

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