The Effect of Risk on Price Responses to Unexpected Earnings

Abstract

We investigate the possibility that earnings response coefficients (ERCs) are increasing in total risk (i.e., the sum of systematic and unsystematic risk). Our study extends the investigation of the role of risk in returns-earnings relations initiated by Easton and Zmijewski (1989) and Collins and Kothari (1989). Using the standard valuation model in which expected dividends are discounted at risk-adjusted rates, those studies show that ERCs should decline with systematic risk because the present value of a revision in expected dividends declines as systematic risk increases. We refer to this possibility as the “denominator effect” of risk on ERCs. In contrast, we posit a “numerator effect” of risk on ERCs. Specifically, we suggest that ERCs may increase with total risk because the sensitivity of dividend expectations to firm-specific news is an increasing function of risk. Our empirical work finds a robust positive relation between ERCs and total risk that is both economically and statistically significant; however, we find little empirical support for a negative relation between ERCs and systematic risk.