Earnings Response Coefficient

The earning response coefficient refers to the anticipated relationship between the returns of the equity and the unexpected earnings announcements of a company. Earning response coefficient is also known as ERC.According to the arbitrage pricing theory of the financial economics, the price of a particular equity shares a theoretical relationship with the information on a particular equity that is available to the market participants.
The efficient market hypothesis says that the equity prices are expected to reflect all the necessary and relevant information on the equity at a given point of time.
Consequently, if any change in the value of the equity occurs, it is understood that this is due to the change in relevant information. There are market participants who are having superior information and they can exploit that information until the share price is affected by the information.

Hence we can say that depending on the changes in the relevant information on a particular equity, which is available in the market, some changes in price of the shares may occur. It can also be said that the earning response coefficient is actually an estimate of the stock price change of a company because of the changes in information supplied in the earnings announcement of the company.
The mathematical expression of earning response coefficient is given below:

R = a + b(ern – u) + e

Here,

R stands for the expected return

(ern-u) takes the value of unexpected earnings

e is the random movement

a stands for the benchmark rate

b stands for the earning response coefficient

The use of earning response coefficient is primarily visible in the research of finance and accounting. To be more specific, the earning response coefficient is applied in the positive accounting research. Positive accounting research is a branch of the financial accounting research that is used for the theoretical analysis of the market depending on the various events of information. ERC is used in the finance research to study the activity of the investors depending on the information events.

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Last Updated on : 1st July 2013

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