The Pricing Effect of Information Risk

Sofie Thode

Student thesis: Master thesis

Abstract

This study investigates the interplay between information risk and equity cost of capital. Inspired by the considerable interest among accounting researchers, companies and investors, the question arises as to whether information risk is a priced risk factor. The paper further seeks to distinguish the innate and discretionary component of information risk in order to analyse their respective pricing effects separately. The innate component represents the part that is attributable to fundamental risk, whereas the discretionary component represents information risk arising exclusively from managerial discretion. An extensive literature review is conducted to outline potential theoretical explanations for the topic at hand. The literature review primarily focuses on literature which relates to the investigation of cost of capital effects that are consistent with a rational asset-pricing framework in which accruals quality captures an information risk factor that cannot be diversified away. A significant part of the academic debate revolves around the quality of accruals. As such, information risk is proxied by accruals quality whereas realised returns are applied to proxy for equity cost of capital. Based on the theoretical background outlined in the literature review, two hypotheses are proposed: 1) there is no difference in the cost of equity capital of firms with poor accounting quality and firms with good accruals quality and 2) there is no difference in the cost of equity capital effects of the innate component of accruals quality versus the discretionary component of accruals quality. In order to test the two hypotheses, a dataset dated from January 1st 1970 to December 31st 2015 containing both financial statement data as well as monthly stock returns is gathered for the US market. Using a two-stage cross-sectional regression approach, the analysis rejects the first hypothesis and concludes that firms with poor accounting quality on average earn higher realised returns suggesting that accruals quality is a priced risk factor. This is significant even if investors fully diversify their portfolios and suggests that investors demand a higher expected return from firms with higher levels of information risk. The findings further suggest that firms can influence their cost of capital by reducing information risk. The results are based on 348 regressions of monthly excess returns on both a three and five factor model augmented with an additional accruals quality risk factor. The same approach is applied for the second hypothesis except the accruals quality factor is separated into its innate and discretionary components. This analysis rejects the second hypothesis as only the innate component is found to have an effect on equity cost of capital. The results are robust to estimating factor loadings on portfolio level as well as controlling for low priced stocks and two-way clustering. The results are however sensitive to the treatment of outliers. In spite of the significant results, the thesis lastly proposes the use of a broader measure of information risk as well as a more accurate measure of cost of equity capital.

EducationsMSc in Finance and Investments, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2019
Number of pages82