Credit Rating, Post-Earnings-Announcement-Drift, and Arbitrage

Abstract

This study first establishes a robust link between credit rating and post-earnings-announcement drift (PEAD). I find strong evidence that PEAD is more salient for firms with low credit ratings. This finding is consistent with the notion that investors are prone to underreact to earnings news from low-credit-rating firms that are characterized by high uncertainty of asset fundamentals. The association between credit rating and PEAD is not driven by traditional information uncertainty proxies such as earnings volatility, cash flow volatility, accrual quality, firm age, idiosyncratic volatility, and analyst forecast dispersion. I further investigate whether transient institutions exploit the differential of PEAD among different rated firms in their arbitrage trades. The results reveal that transient institutions tend to focus their arbitrage on low-credit-rating firms. However, the existence and concentration of PEAD in low-credit-rating firms suggest that transient institutions fail to arbitrage away PEAD among low-rated firms and that the arbitrage strategy is riskier than expected by the transient institutions. This in turn implies that estimation risk associated with pricing the earnings news of low-rated firms plays a substantive role in forming the strong PEAD of these firms.