What is it about?
This paper explains how the actions of skeptical traders can make manipulable earnings reports informative. Our model consists of a price-maximizing manager who chooses a cheap talk report, a profit-maximizing trader who may then seek costly information, and competitive market makers. Since the manager can influence the trader's information acquisition decision, the manager may choose to reveal even bad news to decrease the impact of order flows on prices. The paper provides foundations for treating positive and negative earnings surprises as good news and bad news respectively, even when external auditing cannot constrain opportunistic managers. Testable implications are derived.
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Why is it important?
This is the first paper which formalized the notion of suspicion in traders when they hear managerial reports, and showed how suspicion-induced actions can make managers voluntarily report the truth.
Perspectives
I learnt market microstructure theory by writing this paper.
Professor Utpal Bhattacharya
Hong Kong University of Science and Technology
Read the Original
This page is a summary of: To believe or not to believe, Journal of Financial Markets, February 1999, Elsevier,
DOI: 10.1016/s1386-4181(98)00006-8.
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