Abstract
Using unique new data, we examine whether brokerage trading volume creates a conflict of interest for analysts. We find that earnings forecast optimism is associated with higher brokerage volume, even controlling for forecast and analyst quality, recommendations, and target prices. However, forecast accuracy is also significantly associated with higher volume. When analysts change brokerage houses, they bring trading volume with them, influencing trading volume at the new brokerage. This indicates that analysts drive the volume effects we observe. Consistent with a reward for generating volume, brokerage houses are less likely to demote analysts who generate more volume. Finally, analysts strategically adjust forecast optimism based on expected volume impact. Analysts become more (less) optimistic if their optimistic forecasts in the prior year were more (less) successful at generating volume. However, consistent with higher costs to increasing accuracy, analysts do not update accuracy based on expected volume impact. Overall, our results are consistent with a brokerage trading volume conflict of interest moving analysts towards more optimistic earnings forecasts, despite the volume reward for accuracy.
Highlights
Sell-side security analysts play a significant role in financial markets
We examine the potential conflict of interest derived from one of the primary funding mechanisms for modern sell-side security analysis: brokerage trading commissions
We find that optimism in earnings forecasts is associated with a higher brokerage share of trading volume, even after controlling for forecast and analyst quality, recommendations, and target prices
Summary
Sell-side security analysts play a significant role in financial markets. They provide research and investment advice to institutional and retail investors, and they contribute to firms’ information environments. analysts face conflicts of interest that may cause them to bias their research. We begin by extending prior research by examining whether more optimistic analyst earnings forecasts are associated with a larger share of trading volume for the analyst’s brokerage when the forecasts are released. The first step in examining the potential trading-volume conflict of interest is to examine whether optimistic earnings forecasts yield a higher share of volume for the analyst’s brokerage house. Our study contributes to the literature on sell-side analysts by addressing one of the major potential conflicts of interest that analysts face: commissions-related incentives under the current analyst funding model This contribution is relevant, due to the implementation of the revamped Markets in Financial Instruments Directive (MiFID II) in Europe, which requires that asset managers pay for sell-side research directly and not through trading commissions (Financial Conduct Authority 2017).
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