Economic Links and the Spillover Effect of Earnings Quality on Market Risk

Abstract

Based on the theoretical framework of Lambert, Leuz, and Verrecchia (2007), I predict that higher earnings quality of economically related public firms reduces a firm’s systematic market risk. Using alternative sets of economically related firms, this study provides significant evidence consistent with the prediction. First, a conditional CAPM regression shows that not only a firm’s but also its related firms’ earnings quality lowers the loading of firm excess return on the market factor. Second, regressions based on three-factor models provide similar results. Third, the effects of related firm earnings quality is more pronounced for the subsample with high historical systematic market risk. These results are economically significant and robust in several additional tests. Overall, this study contributes to the literature by providing the first evidence of the long-term externalities of financial information quality in the capital market. The findings have important implications for regulators, scholars, and investors.

Keywords: Economically related firms; Spillover effect; Earnings quality; Market risk; Cost of equity capital