The Effect of Annual Earnings

Announcements on the Chinese

Stock Markets
SHUHONG KONG* AND MAJID TAGHAVI**
Abstract
This paper examines the annual earnings announcement effect of the stock markets
in China. The investigation is based on events analysis and carried out by modeling the
daily changes of stock returns using the M-EGARCH approach, by testing the news
effects of annual earnings announcement on the conditional mean of abnormal return
and the variance of the returns. It is found that a higher than expected earnings
announcement leads to a rise in the conditional mean of stock returns on days before the
news announcement and a fall afterwards. The conditional volatility of the changes are
signicantly reduced by bigger absolute values of reported earnings before the news
announcement and increased afterwards, supporting the rejection of semi-strong-form
efciency. (JEL G10, G12, G14)
Introduction
Many studies on the semi-strong-form efciency of stock market are focused on the
analysis of the information content of annual earnings and dividend announcements.
The purpose of these public disclosure announcements is to provide information that
meets investors needs for decision-making. According to Fama [1991], in a sub-efcient
market, the share price may fail to fully reect all relevant information, and abnormal
returns may be obtained by taking advantage of public information because there is a
signicant time lag between announcement and full incorporation of the information.
Previous empirical studies on annual earning announcements in the Chinese stock
market largely concentrate on the drift effect on the overall market attributed to
information disclosure [Zhao, 1998; Chen and Liu, 1999; Chen and Yang, 1999; Chen and
Chen, 2002], without considering the precise quantitative relationship between yield
change and earnings change given new information disclosure. We investigate these
effects using the M-EGARCH model. We intend to discover the precise quantitative
relationship between the earnings and the yield shift. Specically, the daily changes of
stock prices are modeled by M-EGARCH to ascertain the existence and the nature of the
annual earning announcement effects on the conditional mean and variance of the
changes. In the European and the U.S. markets, most such news announcements affect
stock prices on the days of the information disclosure and the effect would not continue
after the day of disclosure. This means that the European and American markets are
basically semi-strong-form efcient stock markets. In contrast, we will show that the
Chinese markets are not as efcient as the western markets.
International Advances in Economic Research (2006) 12:318Y326 * IAES 2006
DOI: 10.1007/s11294-006-9020-8
*University of International Business and EconomicsBeijing, China and ** University of
NorthumbriaNewcastle upon Tyne NE3 5AJ, UK.
318
This paper will nd evidence of the sub-efcient character of Chinese markets by
means of an EGARCH model. The EGARCH model is based on exponential generalised
autoregressive conditional heteroskedastic model, which was rst put forward by Nelson
[1991]. This model is more apt to explain the asymmetric changes of the conditional
deviation, and the extent of yield change due to information disclosure. The estimated
coefcients of the model would provide us with answers to our questions. This type of
modeling is important in our research because of the following reasons.
First, the model used here is based on the conditional heteroskedasticity property of
the daily changes, so that the results of empirical study are more coincident with actual
condition. Many researchers of Chinese stock markets using other models have often
ignored the adverse consequences of heteroskedasticity.
Second, the model will estimate the exact value of the mean of daily changes of stock
prices in the events window, and the elasticity relating to EPS (earning per share) over
time. This empirical result describes more exactly the effect of annual earnings
announcement. Other studies, on the other hand, only distinguish the difference between
the good and the bad news.
Finally, and more importantly, using the model we can examine and evaluate the
effects of announcement news on the conditional volatility of the abnormal return
changes in the events window. The exact value of the variance in response to the news,
higher volatility due to good news or bad news and the asymmetric reactions towards good
and bad news are also offered by the model.
The rest of the paper is organized as follows. The next section offers a literature review
of the empirical investigations in this area. The following section discusses the nature of
the data and the modeling issues. Then, the paper presents the empirical results. Finally,
the last section concludes the paper.
Literature Review
The theory of rational-informed efcient nancial markets has been extensively
tested for nearly a quarter of a century. Although there has recently been an increase in
empirical research regarding emerging/developing nancial markets, a glance through
the literature reveals that a signicant amount of work needs to be conducted in this
area. It has been noted by Balaban and Kunter [1996] that research on developing
economies nancial markets may offer valuable opportunities for diversication beyond
national markets. Amongst many [Balaban, 1995; Cornelius, 1991, 1993; Muradoglu and
Metin, 1995], Keane [1993] has presented a detailed analysis and empirical investigation
of the Efcient Market Hypothesis (EMH) in developing markets. In particular, as China
becomes more integrated into global nancial markets, any examination of and analysis
based on Chinese stock markets should be of signicant interest to academics, policy
makers, and investors.
Many empirical studies on the European and American capital markets tend to focus
on the reaction speed of the market to important events or other new information.
Particular use has been made of event studies, which examine the extent to which
returns are abnormal in the time period surrounding a public announcement. Numerous
studies have analysed price reactions following specic information disclosures, such as
stock splits, new exchange listings, or earning announcements. Pettengill and Jordan
[1990] found overreaction and, hence, abnormal returns for European and American
markets. In contrast, Zarowin [1989] discovered size anomalies, but found no evidence
for overreaction to news announcements. Amihud et al. [1999] found evidence for the
size of shareholders effect on stock price. Bernard and Thomas [1990] went on to point
CHINESE STOCK MARKETS 319
out that new information exerted its full inuence on the stock price within 1 h after
disclosure. There appears, therefore, to be very little evidence for the European and the
American markets not being semi-strong-form efcient.
In China, however, event studies based on information disclosure only commenced in
the late 1990s. Zhao [1998] looked at the information content from earnings information
disclosure in the Shanghai Stock Market by means of accumulated abnormal returns. He
found evidence of both overreaction and under-reaction. Chen and Liu [1999] examined
the impact of earnings information disclosure in both the Shanghai and Shenzhen
Markets using the OLS. They concluded that earnings announcements are rich enough
in information content to exert a signicant inuence on the market. However, there are
few studies on the precise effect of information disclosure on changes in yield. Moreover,
the previous empirical studies disregard the non-constancy of the dispersal about the
mean of yield and stock price. Real markets often disobey the assumption of constant
deviation due to inuence of various factors. It is necessary to introduce GARCH or
EGARCH models to describe this varying deviation.
There are many other studies where the time varying nature of daily return dispersal
about the mean is modeled using GARCH models. For example, Bollerslev, et al. [1992]
and Ritchken and Trevor [1999] applied the GARCH and EGARCH models to dispersals
about the mean for daily return changes with asymmetric changes of the conditional
deviation. However, no research in this regard has ever been conducted for the Chinese
markets. This paper will use the EGARCH model to investigate the daily change of stock
prices on Chinese markets and discover the precise quantitative relationship between
yield change and earnings change given new information disclosure.
Data and Models
In a semi-strong-form efcient market, the yield should adjust instantaneously to
unanticipated information. However, new information can also increase or reduce un-
certainty in the market. Therefore, it would be expected that volatility (and, hence, the
appropriate risk adjusted return) would also change. There are three probable cases.
First, announcements have no signicant effect on either the mean or the conditional
volatility of the abnormal return changes on the days of their announcements. Second,
announcements signicantly affect the value of the abnormal return and the adjustment
process takes a signicant amount of time. Third, announcements signicantly affect the
conditional volatility.
The rst case indicates that information disclosure has no inuence on the market.
One could infer from this that the information has already been fully impounded into the
price, and that there is a strong-form efciency. The second case indicates temporary
deviation from semi-strong efciency if adjustment is not instantaneous. The third case
indicates that risk/uncertainty associated with a stock may be modied by the in-
formation disclosure.
This paper aims to discover which of the above three cases is most likely to occur in
the Chinese stock markets. By establishing the EGARCH model for the data of daily
change of stock prices on the events window and testing for the overall signicance of the
model, we will be able to nd answers to our questions.
The data includes annual earnings announcement in Shanghai and Shenzhen Stock
Markets, and the daily stock price returns for each stock where there has been an
announcement. The sample data fulll two prerequisites. First, they encompass an
annual earnings announcement within the period under analysis. Second, the requisite
stock market prices are available a year before the annual announcement. In the year
320 SHUHONG KONG AND MAJID TAGHAVI
chosen there were 1,224 listed companies altogether, 698 in Shanghai and 526 in
Shenzhen. There were also 3,672 observations on the earnings and losses announcement
days and 23,680 observations on daily stock price returns in the period around the
announcement day.
The normal period chosen for studies on the European and American modern capital
market is often as long as 10 years, so that the inuence of unusual or extraordinary
factors on earnings information may be reduced or eliminated. Since the Chinese
markets are still at the early stage of development, it is difcult to nd a sample with a
stable group of member rms. Moreover, the very limited experience of trading on the
Chinese stock market means that it is much more difcult to explore what really
constitutes the regular and normal behaviour from which anomalies can be subtracted.
Hence we take the latest year available instead.
The time window wrapped around each annual earnings information disclosure is
j10 days to +10 days, for various earnings announcements, taken place in the year 2001
in both Shanghai and Shenzhen stock markets. The purpose of the exercise is to analyse
the impact of any change in EPS on returns by comparison with the previous year.
Daily returns are dened as follows:
R
t
lnP
t
lnP
t1
100 1
where P
t
is the closing prices of stocks on day t.
Abnormal return is dened as follows:
AR
jt
R
jt

b
RR
j
2
where AR
jj
is the ow of abnormal return of j, and
b
RR
j
is the expected return (normal
return). The expected return is calculated over all n sample data points, while the
abnormal return is calculated over the event period.
b
RR
j

1
n
X
n
t1
R
jt
3
Chen and Chen [2002] show that expression (3) of abnormal return is superior
compared to other complex models, because it ignores the disturbance noise to the
expected return. It could more effectively examine the stock prices reaction on various
events, especially in the case of such events which have weaker inuences on stock
prices.
The EGARCH model is an appropriate technique for any differentiated deviation
modeling, hence, to explain asymmetric change in the conditional deviation. EGARCH
has already been extensively applied in nancial capital sequence analysis. Given the
potential for an increase in deviation, investors would require additional risk premium as
compensation, indicating that the return should be modeled as a function of deviation.
Following a test for serial correlation, the M-EGARCH model chosen here would be of
order (1,1) as follows:
AR
t

0

1
NEWY
t

h

h
t
p
"
t
4
"
t

h
t
p
v
t
ln h
t

0

h
ln h
t1

1
NEWY
t
j j g NEWY
t
f g 5
8
>
>
>
<
>
>
>
:
CHINESE STOCK MARKETS 321
The variable AR
t
is the abnormal return on day t; t = j10, . . . ,+10. The variable
NEWY
t
is
Y
Y
, where Y is the stock price on day j10, and DY is the increase margin of
EPS compared to the previous year. In this model, h
t
is the conditional deviation of
return, and v
t
is a white noise.
Equation (4) represents the conditioned mean of abnormal return, while equation (5)
determines the effect of new information on the deviation of the return. The testing of
the three cases, mentioned earlier, is carried out by examining the sign and the
signicance of the coefcients of the news variables in the conditional mean and variance
equations. The news variables in the conditional mean equation would pick up the news
effects on the mean of the return changes on the days of their announcement. If the
announcements exhibit to have impact on the volatility of the changes, their non-linear
inuence would still be represented in the residuals of the conditional mean equation,
after their linear inuence have been removed. The coefcients of the news variables in
the conditional mean equation convey information regarding the effects of the
announcement on the price changes, which depend on the equilibrium relationship
between the announced economic variable and stocks prices.
As explained earlier, the focus of this paper is on the news effects on the conditional
mean and volatility of the stocks prices changes. Estimated coefcients of the news
variables will reveal which of the three cases is supported. If there are no news effects on
either the conditional mean or variance of the changes, the news coefcients will not be
signicantly different from zero and, hence, case (1) is supported. Case (2) is relevant if
the news variables are signicant only in the conditional mean equation. If the
TABLE 1
Abnormal Return in the Shanghai Stock Market
t Mean Median Max Min Std. Dev. Skewness Kurtosis N
j10 0.333* 0.217 8.042 j5.126 2.176 0.513 4.270 698
j9 0.170 0.267 7.411 j8.842 2.681 j0.315 4.313 698
j8 0.357* 0.685 6.165 j9.896 2.839 j0.545 4.008 698
j7 0.071 0.203 7.601 j6.359 2.499 0.063 3.164 698
j6 0.103 0 9.320 j5.333 2.676 0.636 3.929 698
j5 0.226 0.105 8.292 j6.724 2.652 0.444 3.964 698
j4 0.523* 0.133 9.579 j3.659 2.424 0.883 4.403 698
j3 0.105 0.365 6.276 j7.045 2.338 j0.375 3.675 698
j2 0.414* 0.403 7.696 j4.669 2.228 0.495 3.526 698
j1 0.540* 0.870 6.390 j5.078 2.465 j0.102 2.626 698
0 j0.261 j0.781 6.460 j5.923 2.701 0.289 2.760 698
1 j0.235 j0.309 5.451 j4.535 1.905 0.343 3.412 698
2 j0.030 0 4.791 j4.890 1.906 0.042 3.151 698
3 j0.274 j0.687 5.870 j4.806 2.289 0.611 3.126 698
4 j0.112 j0.216 4.143 j4.076 1.703 0.253 2.958 698
5 0.281 0.175 5.121 j5.087 2.066 0.056 2.702 698
6 0.037 j0.139 5.674 j3.917 1.960 0.550 3.485 698
7 0.034 j0.075 6.551 j6.216 2.166 0.002 4.211 698
8 j0.372* j0.477 3.714 j5.432 1.818 j0.212 3.083 698
9 0.179 j0.179 5.955 j3.533 2.002 0.534 3.180 698
10 0.128 0.044 8.909 j6.06 2.275 0.281 5.144 698
*Signicance at the 5 percent level.
322 SHUHONG KONG AND MAJID TAGHAVI
announcements signicantly affect the stocks prices and raise (lower) the volatility of the
daily changes, the coefcients in the deviation equation will be positive (negative) and
signicant, then case (3) is to be supported.
Empirical Results and Analysis
We have chosen 2,448 observations for EPS: a set of 1,224 for each of the years 2000
and 2001. Of these, 698 cases relate to Shanghai and 526 to Shenzhen. The distributional
information for the 1,224 stocks is given in Tables 1 and 2.
Table 1 shows that there are ve mean daily returns in the Shanghai market relating
to the pre-announcement being signicantly and positively signed, whilst only one such
case can be found being signicant and negatively signed after the announcement. In
Table 2, we found ve cases of signicantly positive estimates relating to pre-
announcement and two negative cases to post announcement. There is also one case of
signicant positive post-announcement in the Shenzhen market. However, these basic
statistical inferences are largely consistent with our basic hypothesis.
The estimated ndings for the M-EGARCH model [equations (4) and (5)] are given in
Tables 3 and 4. Table 3 shows that in the Shanghai market the mean of a
1
is positive and
signicant (at the 5 percent level) ve days before the announcement, while it is positive
and signicant (at the 10 percent level) two days after the announcement. Thus, a 1
percent increase in EPS should on average lead to a 0.1102 percent increase in abnormal
TABLE 2
Abnormal Return in the Shenzhen Stock Market
T Mean Median Max Min Std. Dev. Skewness Kurtosis N
j10 0.243 0.203 8.542 j7.600 2.928 0.003 4.119 526
j9 0.461* 0.359 9.564 j8.106 3.066 0.560 4.122 526
j8 0.292 0.279 8.156 j5.129 2.541 0.458 4.067 526
j7 0.386* 0.170 8.058 j7.933 2.735 0.080 3.693 526
j6 0.420* 0.256 5.988 j6.266 2.551 0.005 2.648 526
j5 j0.230 j0.135 9.573 j5.711 2.349 0.398 5.261 526
j4 0.545* 0.378 7.923 j6.589 2.338 0.262 3.925 526
j3 0.292 0.264 8.464 j8.324 2.431 j0.047 5.359 526
j2 j0.038 0.104 4.871 j5.135 2.278 j0.018 2.654 526
j1 0.439* 0.142 8.358 j3.326 1.866 0.861 5.221 526
0 0.442* 0.064 8.369 j4.953 2.801 0.535 3.187 526
1 j0.054 0 5.283 j3.439 1.998 0.488 2.718 526
2 0.231 0.189 9.592 j3.564 2.036 1.003 6.337 526
3 j0.053 j0.120 7.080 j5.145 1.983 0.462 4.116 526
4 j0.143 j0.149 9.531 j5.147 2.038 1.184 8.416 526
5 0.134 0.279 5.446 j6.772 2.049 j0.404 3.845 526
6 j0.389* j0.196 3.279 j5.291 1.829 0.214 2.740 526
7 j0.015 0 7.031 j6.760 2.208 j0.056 4.078 526
8 j0.381* j0.325 6.436 j6.519 2.483 0.729 5.292 526
9 0.350* 0.135 6.259 j5.512 2.035 0.056 3.372 526
10 j0.037 j0.168 7.648 j3.695 1.944 0.905 4.645 526
*Signicance at the 5 percent level.
CHINESE STOCK MARKETS 323
return ve days before the announcement, followed by a further 0.0797 percent increase
two days afterwards. There is no evidence here for retrenchment. From Table 4 it is
evident that in the Shenzhen market the mean of a
1
is positive and signicant (at the 5
percent level) four days and one day before the announcement, while it is negative and
signicant (at the 10 percent level) ve days after the announcement. Thus, a 1 percent
increase on EPS should on average lead to 0.235 percent and 0.123 percent increases,
respectively, on abnormal return four days and one day before announcement and on
average 0.1 percent decrease after announcement.
The results are indicative of strong impact of NEWY
t
on the conditional volatility of
the abnormal return via parameter b
1
. In the Shanghai market, the estimates of b
1
suggest that volatility is increased by new information three and four days after the
announcement. In the Shenzhen market, by contrast, volatility is reduced three days
before the announcement and increased six days after announcement.
The parameter a
h
is not signicantly different from zero for all periods in both
markets, which indicates that the conditional deviation does not signicantly inuence
the return. This may give rise to the extent of inappropriateness measure of risk, and,
hence, suggesting that a Beta based measure of risk would be more appropriate than
individual volatility. The parameter b
h
is found not to be signicant, indicating that
there is no persistence or autocorrelation in conditional deviation. The parameter g is
signicant in only one case out of four, indicating a rather weak effect of news on
conditional returns.
TABLE 3
Coefcients in M-EGARCH Model in Shanghai Stock Market
T a
0
a
1
a
h
b
0
b
1
b
h
g
j10 0.2627 j0.0526 0.0013
j9 0.1348 j0.0265 j0.0006 0.7326 j0.0978 j0.0609 0.0544
j8 0.3667 0.0074 0.0052 0.7826 0.0195 j0.1002 j0.0282
j7 0.1143 0.0328 0.0013 0.1154 0.0805 j0.1942 j0.0496
j6 0.0590 j0.0331 j0.0028 0.2371 0.0447 j0.2502 j0.0118
j5 0.3724 0.1102* 0.0063 0.4840 j0.0300 j0.2458 0.0866
j4 0.6903 0.0503 0.0049 0.2178 0.0827 0.0016 0.0423
j3 0.1687 0.0215 j0.0074 0.0244 0.0786 j0.0104 0.0350
j2 0.5208 0.0053 j0.0018 j0.0831 j0.0177 0.1740 j0.0223
j1 0.6458 0.0045 0.0056 0.4949 0.0716 j0.0475 0.0594
0 j0.3297 j0.0503 0.0031 1.1655 j0.0716 0.0026 j0.0290
1 j0.2133 0.0147 0.0072 j0.1843 0.0261 j0.0901 j0.0607
2 0.0710 0.0797* j0.0058 j0.3350 0.0109 j0.1899 0.0038
3 j0.2214 0.0400 0.0076 0.0374 0.1098* j0.0992 0.0252
4 j0.1090 j0.0020 j0.0016 j0.6297 0.1229* j0.0193 0.0385
5 0.3220 0.0310 j0.0027 0.1234 0.0622 j0.1826 0.0544
6 0.0236 j0.0100 0.0028 j0.5515 0.0862 0.1006 j0.0138
7 j0.0411 j0.0567 0.0083 j0.2135 0.0103 0.0552 j0.0263
8 j0.3293 0.0325 0.0055 0.0085 j0.0160 j0.0019 0.0335
9 0.0930 j0.0647 j0.0091 j0.2739 0.0524 j0.0914 j0.0290
10 0.1882 0.0453 j0.0078 0.1673 0.0185 j0.1406 j0.0249
*Signicance at 10 percent level, and **signicance at 5 percent level.
324 SHUHONG KONG AND MAJID TAGHAVI
Conclusions
In testing the features of the semi-strong-form efciency in the Chinese stock
markets in terms of the return of annual earnings announcement, an M-EGARCH model
has been applied. It has been demonstrated that the changes of the news variable
signicantly inuence the mean of abnormal return in that the mean of abnormal return
markedly increases four days before announcement, while decreases four days after
announcement. This indicates that there is advanced overreaction in both the Shanghai
and Shenzhen markets towards the annual earnings announcement by four to six days
before announcement, while exhibiting a remarkable rectication of four to six days after
announcement to readjust the overreaction. The overreaction can be attributed to
banking behaviour and advanced information disclosure. A signicant number of
bankers, being closely associated or even colluding with listed companies, take advantage
of their privilege to dominate the market price, contributing to marked information
asymmetry while clusters of followers and speculators propel the overreaction and
generate the abnormal returns for the bankers. In this sense, the Shenzhen and
Shanghai markets fail to represent the semi-strong-form efciency.
Moreover, we have tested the inuence of the annual earnings announcement on the
conditional deviation of the uctuation of the abnormal return, with the conclusion that
it decreases the deviation three to four days before announcement, while increases three
to six days afterwards with relatively small advanced overreaction, but with large
rectication. There are also asymmetric reactions towards good and bad news in
Shenzhen market with more severe uctuation caused by good news. On the basis of
TABLE 4
Coefcients in M-EGARCH Model in Shenzhen Stock Market
T a
0
a
1
a
h
b
0
b
1
b
h
g
j10 0.5015 j0.0385 0.0033
j9 0.3762 j0.1687 j0.0097 0.2082 0.1462 j0.1162 0.0226
j8 0.3466 j0.0417 j0.0039 0.2791 0.0058 0.0307 0.0321
j7 0.4400 0.0490 j0.0059 0.5910 j0.0294 j0.0969 0.0416
j6 0.3785 j0.0381 0.0038 0.7028 j0.1377 j0.0214 j0.0378
j5 j0.1430 0.0800 0.0037 0.1086 j0.0571 j0.0110 j0.0600
j4 0.9023 0.2350** 0.0011 j0.1155 j0.0274 j0.0138 0.0183
j3 0.6080 0.1060 0.0066 j0.0505 j0.1788* j0.1332 j0.0816
j2 0.0693 0.0981 j0.0082 0.0937 0.0496 j0.0167 0.0774
j1 0.5734 0.1227** 0.0025 j0.1677 j0.0226 0.1305 0.0706
0 0.5132 0.0650 0.0003 0.8681 j0.0140 j0.0328 0.1117
1 j0.0605 j0.0057 0.0085 0.2665 j0.0428 j0.0347 0.0309
2 0.2245 j0.0060 0.0109 j0.0152 j0.0498 0.1853 0.0074
3 j0.0742 j0.0195 j0.0029 j0.0336 j0.0176 0.1187 0.0583
4 j0.2275 j0.0770 0.0053 j0.3308 j0.0945 j0.0370 j0.1488**
5 0.0200 j0.1040* j0.0149 j0.0550 j0.0408 0.0464 j0.0243
6 0.3452 j0.0407 0.0025 j0.4524 0.1675* j0.0608 0.0217
7 0.0220 0.0345 0.0080 j0.0281 0.0891 j0.1034 0.0167
8 0.4270 0.0416 0.0067 0.1985 0.0123 j0.1682 0.0327
9 0.3866 0.0332 0.0019 0.3855 j0.0633 0.0117 0.0808
10 j0.0211 0.0149 0.0022 j0.2608 0.1060 0.0392 0.0428
*Signicance at 10 percent level, and **signicance at 5 percent level.
CHINESE STOCK MARKETS 325
our empirical investigation, it can be said that this paper supports the conclusion that
the Chinese stock markets fail to represent a semi-strong-form efcient towards annual
earning announcement.
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