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This paper examines the relative risk of good-news firms, i.e., those with high standardized unexpected earnings (SUE), and bad-news (low SUE) firms using a stochastic discount factor approach. We find that a stochastic discount factor constructed from a set of basis assets helps explain post-earnings-announcement drift (PEAD). The risk exposures on the pricing kernel increase monotonically from the lowest to highest SUE sorted portfolios. Specifically, good-news firms always have higher risk exposures than bad-news firms in both 10 SUE sorted portfolios and 25 size and SUE sorted portfolios. However, the estimated expected risk premium is too small to explain the observed magnitude of returns on the PEAD strategy. Our risk adjustment can explain only about one-fourth of the total magnitude of the average realized return to the PEAD strategy. As a result, the average risk-adjusted returns of earnings momentum strategies are mostly positive and significant. Overall, our results support the view that at least some portion of the returns to the earnings momentum strategies examined represent compensation for bearing increased risk.

Post-earnings-announcement drift (PEAD), or earnings momentum, refers to the fact that stock returns continue to drift in the direction of earnings surprises for several months after earnings are announced. It is well documented in the literature that a simple trading strategy that is long in stocks with the highest earnings surprises and short in stocks with the lowest earnings surprises generates significantly positive abnormal returns (e.g., Chordia and Shivakumar, 2005). PEAD is still robust after its initial discovery by Ball and Brown (1968). Subsequent studies have shown the robustness of earnings momentum using different samples and methods or using evidence on an international scale.1 While PEAD has been robust over the four decades, interpretations of this phenomenon are less clear. In a (semi-strong form) efficient market, all public information released into the market should be instantly reflected in stock prices, because investors immediately adjust their expectations about future earnings. Thus, returns on trading strategies that use only public information should display no abnormal patterns. Evidence of such abnormal returns on earnings momentum may therefore be interpreted as going against the efficient market hypothesis. For instance, Bernard and Thomas (1990) suggest that earnings momentum is a manifestation of a delayed response to the information in earnings announcements. Tests of market efficiency, however, are always necessarily joint tests of market efficiency and the asset pricing model used to determine the expected return ( Fama, 1970 and Roll, 1977). All studies that show earnings momentum rely on specific pricing models. For example, Bernard and Thomas (1990) adopt the five factor model of Chen et al. (1986). Chordia and Shivakumar (2005) use a factor related to news about future inflation. However, if the pricing models used in such studies are mis-specified, the abnormal returns inferred from their use are incorrect as well. That is, such studies may suffer from a “bad model” problem, as Fama (1998) points out. In this paper, we revisit the relative risk of good-news firms, i.e., those with high standardized unexpected earnings (SUE), and bad-news (low SUE) firms. Rather than choosing a particular pricing model, we take an alternative approach using a stochastic discount factor, first proposed by Chen and Knez (1996).2 This approach initially extracts the stochastic discount factor, or pricing kernel, from a set of basis assets, then uses these to price other assets. In contrast to studies that rely on a particular pricing kernel implied by a specific pricing model, this approach retrieves a set of admissible pricing kernels based on minimal restrictions, such as the law of one price.3 Therefore, this approach allows us to examine whether PEAD can be explained with the minimal restriction of equilibrium in securities markets (Ahn et al., 2003a). We document two main results. First, a stochastic discount factor constructed from a set of basis assets helps explain PEAD. The risk exposures on the pricing kernel increase monotonically from the lowest to the highest SUE-sorted portfolios. Specifically, good-news firms always have higher risk exposures than bad-news firms in both 10 SUE sorted portfolios and 25 size and SUE sorted portfolios. Further, our results remain unchanged when we choose alternative basis assets, impose the additional restriction that the pricing kernel be positive, and allow investors’ expectations to vary depending on public information. Second, even though a pricing kernel extracted from a set of basis assets goes in the right direction in explaining PEAD, the estimated expected risk premium is too small to explain the observed magnitude of the earnings momentum. Specifically, for 10 SUE sorted portfolios, our constructed pricing kernel can explain only about 25% of the average observed earnings momentum profit. The average realized return to the PEAD strategy is 1.60% per month, whereas the average expected return to the PEAD strategy is 0.40%. Similar results are obtained for 25 size and SUE sorted portfolios: the portion that our risk adjustment can explain varies from 20% to 40% depending on the size quintile. As a result, the average risk-adjusted returns of earnings momentum strategies are mostly positive and significant. Our results support the view that at least a portion of the returns to the PEAD strategy represent compensation for bearing increased risk. That is, good-news firms outperform bad-news firms because the former have greater risk exposure than the latter. Given that our analysis imposes only the minimal restriction of equilibrium in securities markets, the fact that previous studies fail to show cross-sectional differences in risk to be the source of profits to the PEAD strategy may be attributable to the use of mis-specified pricing models. Several other studies provide risk-based evidence of PEAD. Kim and Kim (2003) construct a risk factor related to unexpected earnings surprises, and document that this risk factor helps to reduce an abnormal return to the PEAD trading. Sadka (2006) shows that liquidity risk can explain a portion of PEAD returns.4 We add to this literature by adopting an alternative approach not considered in the literature. This paper proceeds as follows. Section 2 presents empirical method. Section 3 describes the data. Section 4 reports our empirical results. Section 5 presents our conclusions.

We reassess the risk-based explanation for the profitability of earnings momentum. Instead of relying on a particular asset pricing model, we take an equilibrium pricing model that satisfies some minimal restrictions. We document two main results. First, a stochastic discount factor constructed from a set of basis assets goes a long way toward explaining the PEAD. Stocks with positive earnings surprises have higher risk exposure on the pricing kernel than those with negative earnings surprises. As a result, the returns to the PEAD strategy that buy good-news firms and sell bad-news firms have a positive risk exposure. This evidence applies to both 10 SUE portfolios and 25 size and SUE portfolios. Further, our results remain unchanged when we choose alternative basis assets, impose an additional restriction that the pricing kernel to be positive, or allow investors’ expectations to vary depending on public information. Second, although our constructed pricing kernel goes in the right direction, the expected profit to the PEAD strategy is far too small to explain the realized magnitude of the PEAD. Our risk adjustment can explain only about one-fourth of the total magnitude of the average realized return to PEAD strategy. As a result, the average risk-adjusted returns of earnings momentum strategies are mostly positive and significant. Our first result supports the view that at least a portion of the returns to the PEAD strategy represent compensation for bearing increased risk. In other words, good-news firms outperform bad-news firms because the former have more risk exposure than the latter. Since our analysis imposes only the minimal restriction of equilibrium in securities markets, the reason that previous studies fail to show cross-sectional differences in risk to be the source of profits to PEAD strategy may be due to the fact that mis-specified pricing models were used. Given that abnormal returns on the PEAD are still positive and significant after our risk adjustment, we cannot rule out the possibility that unexplained profits to PEAD are due to investor underreaction-related mispricing (Bernard and Thomas, 1990).