Sarbanes-Oxley: changes in risk premium and return volatility

Abstract

Purpose – The purpose of this paper is to examine if the enactment of Sarbanes-Oxley (SOX) resulted in lower risk premium and return volatility in the US stock markets. The paper examines the two components of excess return (total risk premium) separately: the amount of volatility (risk) and the unit price of risk (risk premium). Design/methodology/approach – The authors use a Component Generalized Autoregressive Conditional Heteroskedasticity approach to estimate the permanent and transitory component of share price volatility. The authors then use the predicted volatility to measure the unit price of risk and its changes due to the enactment of the SOX Act. Findings – The results regarding excess returns indicate that the implementation of SOX had a positive effect on the market. A positive effect means a steady decrease in required excess rates of returns due to the implementation of SOX. The years leading up to the implementation of SOX are characterized by significant sources of uncertainty. Around the implementation of SOX, the authors observe a long-term reduction in return volatility (risk), and a temporary reduction in the unit price of risk. Subsequent to the implementation, investors gained confidence in the effectiveness of internal controls over the financial reporting process, which helped in reducing the information risk and, therefore, the risk premium. Research limitations/implications – The authors find that total risk premium decreased over extended periods. The authors conclude that the enactment of SOX helped in reducing the uncertainty in the US capital market resulting in a reduction of total risk premiums and hence the cost of capital. Practical implications – The results have implications for policy makers, investors and researchers in general and those in the US markets in particular. The results are important because it allows policy makers and regulators to improve on how they design and implement accounting, market and finance regulations and reforms. Social implications – The study shows how financial markets react to regulations and the authors also provide information on investors’ reaction as firms adjust to changing regulations. The results of the study allows regulators to potentially use a more refined or targeted approach when introducing new regulations. It also allows investors to make informed investment decisions as they relate to risk premium requirements, which in turn may allow investors to allocate capital more efficiently. Originality/value – There are many studies concerning the enactment of SOX but few, if any, existing studies examine the original intent of SOX: to calm the US equity markets and restore market confidence from a return volatility perspective. The results have implications for policy makers, investors and researchers in general and those in the US markets in particular. The results are important because it allows policy makers and regulators to improve on how they design and implement accounting, market and finance regulations and reforms.