A theory of risk disclosure

In this paper, we consider the price effects of risk disclosure. We develop a model in which investors are uncertain about the variance of a firm’s cash flows and the firm releases an imperfect signal regarding this variance. In our model, uncertainty over the riskiness of a firm’s cash flows leads...

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Bibliographic Details
Published in:Review of accounting studies 2017-12, Vol.22 (4), p.1459-1491
Main Authors: Heinle, Mirko S., Smith, Kevin C.
Format: Article
Language:English
Subjects:
Accounting/Auditing
Business and Management
Cash flow
Corporate Finance
Cost of capital
Disclosure
Prices
Public Finance
Risk premiums
Uncertainty
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Summary:In this paper, we consider the price effects of risk disclosure. We develop a model in which investors are uncertain about the variance of a firm’s cash flows and the firm releases an imperfect signal regarding this variance. In our model, uncertainty over the riskiness of a firm’s cash flows leads to a variance uncertainty premium in its price. We demonstrate that risk disclosure decreases the firm’s cost of capital by reducing this premium and that the market response to risk disclosure is small when the expected level of risk is high. Moreover, we find that firms acquire and disclose more risk information when their cash flow risk is greater than expected. Finally, we demonstrate that in a multi-asset setting, only risk disclosure concerning systematic risks will impact the cost of capital.
ISSN:1380-6653
1573-7136
DOI:10.1007/s11142-017-9414-2