Keeping your cards close to your chest may be a time-honored corporate strategy. But it has a measurable cost. New research by two Yale School of Management finance professors shows that investors demand more return from corporations that have low levels of disclosure.
In “Information asymmetry raises the cost of capital,” James Choi and Hongjun Yan examine data from China, Finland and the US and determine that information asymmetry – a situation where pertinent information is known to some but not all parties involved in a transaction – raises companies’ cost of capital, inhibiting investment and long-run economic growth.
The typical economic argument about corporate/investor information asymmetry is that lack of information may force investors to demand more return to offset the risk that they are not seeing all the company’s warts. However, portfolio theory holds that investors can diversify away this risk – a belief that depends on a Gaussian distribution of returns demanded per unit of disclosure. Choi and Yan’s research implies the distribution has a strong skew.
Choi and Yan’s study puts a number on the additional yield investors demand. “After controlling for other known determinants of stock returns, the average return of stocks in the top quintile of predicted information asymmetry is 10.8 percent per year higher than that of stocks in the lowest quintile of predicted information asymmetry. In other words, investors charge a higher cost of capital to companies whose stock contains more information asymmetry,” they write.
Analysts helpfully reduce information asymmetry, the paper notes. Choi and Yan quote work by researchers Byron Kelly and Alexander Ljunqvist, published in the Review of Financial Studies 25, “Testing asymmetric-information asset pricing models” (2012) in which those researchers demonstrate that analyst coverage of a company decreases information asymmetry. “They show that bid-ask spreads, illiquidity, and return volatility around earnings announcements – which should be positively correlated with information asymmetry – increase following unrelated [analyst] coverage terminations.”