How Much Does the Market Know?

Abstract

Market participants acquire different types of information from many sources to inform their trading decisions. This paper uses structural estimation to quantify the amounts of two types of information that the market has: fundamental information – about firm value – and misreporting incentives information –about managers’ incentives to manage earnings. I further measure accounting quality and price efficiency that result from the market’s information endowment. I find that, before the manager’s report is released, the market knows 19.5% of fundamental and 36.6% of misreporting incentives information available to the manager. In equilibrium, accounting quality increases in the market’s fraction of fundamental information and decreases in the market’s fraction of misreporting incentives information, while price efficiency increases with both information types. The elasticity of accounting quality (price efficiency)with respect to the market’s fundamental information is 0.065 (0.217), and with respect to the market’s misreporting incentives information is -0.154 (0.059). I apply my technique to measure the amount of information that the market learned after the compensation disclosure regulation in 2006 and find that the fraction of misreporting incentives information in the market’s hands increased more than 1.5 times: from 21.8% to 38.1%. As a result, equilibrium accounting quality (price efficiency) decreased by 2.87%(increased by 1.30%).