Board of Governors of the Federal Reserve System

June 2011

Limited Market Participation and Asset Prices in the Presence of Earnings Management

Bo Sun

Abstract:

We examine the role of earnings management in explaining the properties of asset prices and stock market participation. We demonstrate that investors' uncertainty about the extent of manipulation can cause excess movements in stock price relative to fluctuations in output. When faced with information asymmetry about fundamentals in the presence of earnings management, investors demand a higher equity premium for bearing the additional risk associated with their payoffs. In addition, when investors have heterogeneous beliefs about managerial manipulation, the dispersion in belief endogenously gives rise to limited stock market participation. Our model suggests that the increasing stringency of corporate governance and varying composition of investors may have played a role in the contemporaneous run-up of market participation rates in the recent years.

Keywords: Earnings management, excess volatility, equity premium, limited stock market participation

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