Effects of Disclosure Quality on Market Mispricing: Evidence from Derivative- Related Loss Announcements
Korea Universicty Business School
It is well understood that investors require value-relevant information on a firm’s future profitability and risks to assess its equity value correctly. However, information asymmetries and agency problems prevent managers from providing investors with value-relevant information in an effective manner. One solution to this problem is to require managers to fully disclose their private information. In fact, one of the main purposes of regulating corporate disclosure is to increase the amount of value-relevant information available to the public on a timely basis. Although previous studies have generally suggested that the level of disclosure is positively related to stock market efficiency, it remains unclear whether an increase in the amount of information (regardless of its quality) can guarantee a better-functioning stock market. This is because such studies have not explicitly differentiated amount from quality when measuring the level of information provided in disclosures. Our study fills this gap in the literature by providing a direct analysis of the relationship between disclosure quality and the market’s mispricing of disclosed information.
We focus on the Korean stock market, which provides a unique empirical setting allowing us to differentiate clearly between high-quality disclosure and low-quality disclosure. Recently, Korean exporters hedged against foreign exchange risk using knock-in/knockout (KIKO) option contracts (over-the-counter instruments). Some firms maintained an over-hedged position through their KIKO contracts and thus incurred enormous amounts of derivative-related losses when the Korean won depreciated sharply against the U.S. dollar during the second half of 2008. In contrast, non-over-hedged firms with derivative related losses are just hedging against the foreign exchange risk associated with their underlying export contracts or other assets denominated in a foreign currency, and thus such losses should be offset by corresponding gains from those contracts or assets. Since the Korean regulations require a timely disclosure of such derivative-related losses (but not the offsetting gains from underlying foreign currency position) within two business days upon recognition, such loss disclosure may occur well before the release of corresponding quarterly financial statements, which contain the information necessary for differentiating over-hedged firms from non-overhedged firms. We propose that stock market should react negatively upon disclosure only for overhedged firms when not only derivative-related losses but also quarterly financial statements are disclosed at the same time.
We compare the stock market’s responses to the full-disclosure and incomplete-disclosure groups following 131 derivative-related loss announcements in Korea from March 2008 to June 2009 where we classify the announcement of derivative-related losses by firms issuing quarterly financial statements at approximately the same time as “full disclosure” (i.e., high-quality disclosure) and that by firms issuing the statements at a later date as “incomplete disclosure” (i.e., low quality disclosure). Our results indicate that for the full-disclosure group, market’s initial reactions to derivative – related losses are negative only for over-hedged firms, but not for non-over-hedged firms supporting our hypothesis. In contrast, for the incomplete-disclosure group, investors’ initial reactions are negative not only for over-hedged firms, but also for non-overhedged firms. Moreover, within the incomplete disclosure group, we find that investors correct their mispricing of derivative related losses for nonover-hedged firms when quarterly financial statements become available at a later date. These results suggest that an increase in the amount of information may not necessarily facilitate a more rational assessment of firms’ equity value. To the contrary, a simple increase in the amount of low-quality information might actually lead to greater market mispricing.
Jaiho Chung, Hyungseok Kim, Woojin Kim, Yong Keun Yoo, (2012). “Effects of Disclosure Quality on Market Mispricing: Evidence from Derivative-Related Loss Announcements”, Journal of Business Finance and Accounting