Empirically, all else equal, these effects predict a positive relation between heterogeneity in
investor informedness and trading volume around earnings releases. Moreover, heterogeneity in
investor informedness may affect the behavior of bid–ask spreads around the announcement.
Heterogeneity in investor informedness prior to the announcement can result in an adverse selection
problem (e.g., less informed investors recognizing that they are less informed and being unwilling to
trade against better informed investors), leading to larger bid–ask spreads prior to the announcement.
The arrival of information in the form of a public announcement makes less informed investors
relatively more informed. The resulting convergence in the level of informedness of investors can
reduce information asymmetries between investors. By reducing information asymmetries between
investors and mitigating the adverse selection problem, the public release of earnings information can
reduce bid–ask spreads. Thus, our empirical prediction is that the reduction in bid–ask spreads after the
announcement would be more pronounced if there were greater differences in investor informedness
prior to the announcement.
While our main hypothesis has re ceived more support in prior th eoretical work, a competing
effect may emerge. If differen ces in the information ability of investors translate into di fferences in
investor ability to interpret th e announcement information, th e announcement may in some cases
increase the information asy mmetry between less informed and better informed inves tors and result
in adverse selection. In Kim and Verrec chia (1994), heterogeneity in inv estor ability to interpret the
announcement information in creases information asymmetr y and widens bid–ask spreads after the
announcement. Notably, t heir model predicts higher bid–ask spreads as well as higher tr ading
volume for such firms. At the sam e time, George, Kaul, and Nimalen dran (1994) show that under
some conditions heterogene ity in the information ability of i nvestors can increase spread s and
decrease trading volume.
In their model, differences in the informatio n ability of investors imply
differential ability to interpr et announcement information, whi ch results in adverse selection and
increases transaction costs . Thus, the relationship between d ifferential precision and volu me
becomes ‘both indirect and amb iguous’once transaction co sts are endogenized. Heter ogeneity in
the information ability of investors has two competing eff ects: increased information-driven trading
and reduced liquidity trading (caused by increased transaction cos ts as a result of adverse selection).
Whether the two effects offset e ach other depends on the impact of in creased transaction costs on
liquidity trading. General ly, public announcements of inf ormation tend to reduce informa tion
asymmetries between investo rs. However, if heterogeneit y in information ability affects th e
processing of announcement infor mation in a manner that increases adverse s election, investor
heterogeneity could incr ease abnormal spreads around the announcement and reduc e abnormal
Ultimately, the effect of differences in the information ability of investors on volume and spreads
around earnings announcements is an empirical question. We are able to disentangle our main
hypothesis (investor heterogeneity increases the volume of trading and reduces spreads around
announcements) from competing effects (investor heterogeneity reduces volume and increases spread)
as they have contrasting empirical predictions.
Our empirical setting relies on earnings announcements for two reasons. First, the release of
earnings news is a well-documented source of new information carefully watched by the market,
so it is relevant for investors. Second, unlike other disclosures, the content of an earnings release
Adverse selection caused by the presence of less informed and better informed investors has also been modeled in the
context of share repurchases in Brennan and Thakor (1990) and Lucas and McDonald (1998). More generally, the argument
that uninformed liquidity traders that have discretion with respect to the timing of their trades may trade less when
information asymmetry is high is presented in Admati and Pfleiderer (1988) and Foster and Viswanathan (1990).
KNYAZEVA ET AL.