Abstract
We examine the link between the scarcity of arbitrage capital and investors’ response to firms’ earnings information. The cost of financing levered investment strategies (i.e., investing with borrowed funds) increases in the risk profile of the securities being traded. As a result, when capital is scarce, levered traders face heightened incentives to tilt their portfolios in the direction of firms’ earnings information as an indicator of lesser risk because doing so mitigates financing constraints. Our results suggest that these investors become more responsive to firms’ earnings announcements when capital is scarce. Moreover, market prices display a stronger reaction to firms’ announcements and less postearnings announcement drift. Together, our findings suggest the scarcity of arbitrage capital spurs both the use of and responsiveness of market prices to firms’ earnings news. This paper was accepted by Brian Bushee, accounting. Supplemental Material: The online appendix and data are available at https://doi.org/10.1287/mnsc.2022.4538 .
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