Flight-To-Earnings: The Role of Earnings in Periods of Capital Scarcity
50 Pages Posted: 10 Mar 2017 Last revised: 2 Feb 2021
Date Written: January 31, 2021
We examine the link between the scarcity of arbitrage capital and investors’ response to firms’ earnings information. The cost of financing levered investment strategies (i.e., investing with borrowed funds) increases in the risk profile of the securities being traded. As a result, when capital is scarce, levered traders face heightened incentives to tilt their portfolios in the direction of firms’ earnings information as an indicator of lesser risk because doing so mitigates financing constraints. Our results suggest these investors become more responsive to firms’ earnings announcements when capital is scarce. Moreover, market prices display a stronger reaction to firms’ announcements and less post-earnings announcement drift. Together, our findings suggest the scarcity of arbitrage capital spurs both the use of, and responsiveness of market prices to, firms’ earnings news.
Keywords: Earnings, Capital Scarcity, Active Investors
JEL Classification: M40, M41, G10, G11, G14, G24
Suggested Citation: Suggested Citation