Motivation and the Hypotheses

314 However, when one can observe informational asymmetry in capital markets and whenever new disclosure regulations are introduced, benefits for individual investors, firms, and accountants need to be compared with additional costs incurred by all agents involved. That is, one has to inquire whether there is positive value added from newly disclosed information Demski, 1972, p.66, and Proposition 5. However, social consequences are generally impossible to assess due to Arrow‘s impossibility theorem Demski, 2003, pp. 429-431. Thus it is difficult to judge whether new disclosure has moved the economy into Pareto improvement. 37 Moreover, Feltham and Christensen 1988 demonstrate that external reporting provides a basis for Pareto improvement only if those reports lead firms to better production decisions, and that the revelation of firm- specific risk does not matter much when investors are well-diversified. In spite of these negative views on the effective assessment of the new disclosure rule, we still believe in the efficiency of competitive equilibrium when private information eventually gets fully impounded into the rational expectations equilibrium price Hellwig, 1980, Kyle 1985. That being the case, both the identification of the ex ante degree of the existence of private information in the price discovery process O‘Hara, β00γ and the quantitative assessment of the ex post changes triggered by the introduction of the new regulation rule are worthwhile queries to be empirically explored. 38 This is the main purpose of this study and we employ the PIN concept for this purpose. First, we state our first two hypotheses: H1: As the new quarterly reports begin to be disclosed in capital markets, the probability of private information-based trade will decrease. H2: The firms which report quarterly financial statements are accompanied by lower probability of private information-based trade than are firms which do not report. We also infer that the degree of informational asymmetry is strongly related to the liquidity of the stock, because informational asymmetry means there is wider disagreement among traders about the true quality of the firm, which triggers wider spreads of limit price orders, and also may even restrain traders from trading stocks if there exists too much uncertainty about the true quality of the firm. Easley and O‘Hara 2004, for example, demonstrate within their rational expectations equilibrium model that stocks with higher private information weights reach lower equilibrium prices and thus, an ex ante higher cost of capital to compensate for this information risk Diamond and Verrecchia, 1991. In the context of interim reporting, Yee 2004 constructs a microstructure model with market makers, analysts, and liquidity traders, and shows ibid., Proposition 3 that increasing reporting frequencies improves the stock liquidity at each announcement date. 37 The proposal from the aspect of the equity concept is conducted by Lev 1988 with regard to the accounting policy context. It is outside the scope of this research. 38 Note that Laffont 1985 also demonstrates that ex post fully revealing rational expectations equilibrium is ex post Pareto optimum. 315 In microstructure studies it is widely assumed that the more illiquid stocks have higher risk and hence higher ex ante expected returns O‘Hara, 1995. So we also look at the relationship between private information-based trade and the stock liquidity from this aspect. Thus, based on the PIN variable we raise our third hypothesis: H3: When the probability of private information-based trade of a stock decreases, the liquidity of this stock will increase. Once again, we are only interested in identifying the association and will not make any further value judgments even if we find evidence to support our hypothesis H3. In order to do that, we need to use the correct form of asset pricing theory to control for systematic risks of stocks and it is outside the scope of this research. 39 This is not the main purpose of the paper and our research focus is identifying the distribution of private information-based trades and their changes relating to the introduction of new disclosure regulation rules. It will also give us a clue to identify the price discovery process of stock trading in Japan in relation to the new disclosure rule. Furthermore, it will give us insight into investigating how changes in private information-based trade are related to stock liquidity measures. In this sense our research is purely descriptive but at the same time it provides us with an important insight about changes in the informational structure of capital markets triggered by the introduction of a new disclosure regulation. One question remaining is whether the frequency of disclosure increases the informational uncertainty. It is outside the scope of this research because we will not investigate the price andor volume reactions on and around the announcement dates of quarterly reports. However, we cite evidence by Mensah and Werner 2008 which shows that price volatility is higher in countries with a quarterly reporting environment like the U.S. and Canada than in countries with a semi-annual reporting environment like the U.K. and Australia. 40 Also, Atiase et al. 1988 raise the issue of timeliness of financial reports and find that it is strongly related to size, and that a longer delay is associated with smaller price reactions, suggesting more information inflow from other channels. So it seems that more timely disclosure increases price volatility. But again, this is outside the scope of this research.

2.3 Previous Studies on PIN and Interim Reports

The most pertinent study related to the current paper is Duarte et al. 2008. They use the estimated PIN variable as a proxy variable to measure the degree of informational asymmetry and find that the Regulation FD affects the cost of capital, using the PIN variable with other control variables. In Duarte et al. 2008 the estimated PIN and other variables are used as independent variables to predict 39 Recently, Kubota and Takehara 2009b addressed this issue and found that both the systematic component and the idiosyncratic component of liquidity risk are significant to explain stock returns. 40 In an early article, May 1971 finds that the price-change response to quarterly earnings was less, but not significantly less than the response for annual earnings. 316 changes in the cost of capital of firms after the Regulation FD was introduced in 2000. Their main finding was that NASDAQ firms were more strongly affected and costs of capital for these firms increased, suggesting that smaller firms bear more increased costs due to the new disclosure rule. In other PIN related studies, Vega 2006 analyzes both the behavior of the post announcement return drifts and changes in the PIN variable around the earnings announcement dates with U.S. data. She finds that the order arrival rate is more important than degrees of private information in explaining post-announcement drifts. In other studies, the relationship between the PIN variable and the order placement strategy is analyzed by Ellul et al. 2003 with NYSE data and the relationship between the PIN and credit rating as public information is analyzed by Odders-White and Ready 2003, again for U.S. data. For the Paris stock market, Atkas et al. 2003 investigates informational effects of corporate events like mergers and acquisitions using the PIN variable. As for the Japanese evidence, Kubota and Takehara 2009a estimate the PIN values for Tokyo Stock Exchange firms and report the comparable parameter values for Japan with U.S. firms estimated by Easley et al. 2002. These results confirm the robustness of PIN estimates across international markets with different market designs. For empirical evidence on quarterly report disclosure and the effect of the timing of the interim reports, the former goes back to the late 1960s using U.S. data. One of the earliest empirical studies using quarterly reports is Green and Segall 1967. They reach a negative conclusion that the first quarter earnings figure does not help forecast annual EPS figures, while Brown and Niederhoffer 1968 find the contrary. 41 Brown and Kennely 1972 use another Ball and Brown methodology and find that advanced knowledge of quarterly earnings can enhance abnormal returns of portfolios relative to the portfolio strategy based solely on annual earnings. This finding is further supported by Foster 1977, who finds that abnormal returns surrounding the interim report announcements are twice as large as ones obtained from annual reports. McNicholas and Manegold 1983 conduct a study using volatility estimates with a sample of 34 firms listed on the AMEX in 1961 and 1962. These firms began to publish quarterly reports according to the then new rule by the AMEX, and McNicholas and Manegold find that the variance of abnormal returns obtained from annual reports decreased upon the enactment of the new disclosure rule, and thus support the hypothesis that additional disclosure of quarterly reports helps decrease the price uncertainty surrounding announcement dates of annual earnings. On the other hand, as stated above, Mensah and Werner 2008 have shown that price volatility is higher in countries with quarterly reporting, like the U.S. and Canada, than in countries with semi-annual reporting like the U.K. and New Zealand. Also, Atiase et al. 1988 studied timeliness of financial reports and showed that it is strongly related to the size, and that a longer delay is associated 41 See Kaplan 1978 for a review of initial literature in this field which investigated the information content of interim reports.