Market Liquidity and Trade Reactions to Accounting Disclosures

Lin, Y. M. 2003. Market Liquidity and Trade Reactions to Accounting Disclosures. NTU Management Review, 13 (2): 137-172

Yi-Mien Lin, Professor, Department of Business Administration and Graduate Institute of Accounting, National Chung Hsing University

Abstract

The analysis of capital markets generally depends on assumptions about the structure of market information and about how traders process information. The various equilibrium paradigms used in the research on asset market behavior differ in their assumptions with regard to the amount of information conveyed in price and the information sets used by traders for their portfolio decisions. This paper analyzes market responses to accounting disclosures with a two-period (three-date) noisy rational expectations model. There are three types of risk-neutral agents: a market maker, informed traders, and liquidity traders. The informed traders receive private signals and the firm releases an accounting report at the first and second dates, respectively. Our model considers two settings where the sequence of prices can either fully reveal or partially reveal private signals. We investigate trading volume responses to a financial accounting disclosure at the time of announcement under these frameworks. Furthermore, we examine how the level of information asymmetry and the degree of liquidity affect the magnitude of trading volume reaction.
Conclusions of this paper are as follows. First, if the private signals are not fully revealed in the sequence of prices, trade in the risky asset occurs at the second date with trading volume arising from both informed and liquidity trading. Second, no informed trading takes place for the risky asset at the second date when the private signal is fully revealed by either a public announcement or the price sequence. This implies that no informed traders submit orders for the risky asset at date 2 and all demand orders for the risky asset are from liquidity traders. Third, in the setting of partially revealing private signal, market liquidity at date 2 is increasing in both the precision of a public announcement and the number of liquidity traders, and decreasing in the diversity of opinion among informed traders.
 


Keywords

Public disclosures Information asymmetry Market liquidity Noisy rational expectations model


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