Earnings response coefficient

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[edit] Earnings Response Coefficient

Earnings Response Coefficient (ERC) expresses the relationship between equity returns and unexpected earnings announcements.

The efficient market hypothesis posits that equity prices reflect all relevant information at a given time. Consequently, any change in equity value results from a change in relevant information. To this end, the earnings response coefficient measures equity returns related to unexpected earnings information.

Generally, the ERC is expressed mathematically as follows –

$R = a + b (e r n - u) + e$

Where –

R = the expected return

a = benchmark rate

b = earning response coefficint

(ern-u) = unexpected earnings

e = random movement

There is some debate concerning the nature and strength of this relationship. As demonstrated in the above model, the ERC is generally considered to be the slope coefficient of a linear relationship between unexpected earnings and equity return. However, certain research results suggest that the relationship is nonlinear.

[edit] See also

CAPM

Arbitrage Pricing Theory

[edit] References

Collins, D. W. and S. P. Kothari (1989), 'An Analysis of Intertemporal and Cross-Sectional Determinants of Earnings Response Coefficients', Journal of Accounting & Economics, Vol.11, No.2/3 (July), pp. 143-81.

Chambers, Dennis J.; Freeman, Robert N.; Koch, Adam S (2005) The Effect of Risk on Price Responses to Unexpected Earnings. Journal of Accounting, Auditing & Finance, Vol. 20 Issue 4, p461-482

Kormendi, Roger & Lipe, Robert, 1987. "Earnings Innovations, Earnings Persistence, and Stock Returns," Journal of Business, University of Chicago Press, vol. 60(3), pages 323-45