Journal Article Analyzes Pre-Announcement and Event-Period Private Information

Journal of Accounting and Economics 24 (1997) 395—419
Pre-announcement and event-period private

information
Oliver Kim!, Robert E. Verrecchia",*
! Robert H. Smith School of Business, University of Maryland at College park, College Park, MD
20742-7215, USA
" The Wharton School, University of Pennsylvania, 2400 Steinberg-Dietrich Hall, Philadelphia, PA
19104-6365, USA
Received 1 March 1997; received in revised form 1 November 1997
Abstract
Pre-announcement information is private information gathered in anticipation of

a public disclosure. Event-period information is private information useful in conjunc-
tion with the announcement itself. Typically rational models of trade are based exclus-
ively on one type of information. Such models are less descriptive of real market settings
and misspecified empirically. Therefore, we introduce a model of rational trade with both
features and discuss its implications. ( 1997 Elsevier Science B.V. All rights reserved.
JEL classification: M4; G14
Keywords: Capital markets; Trading volume; Announcements
1. Introduction
The purpose of this paper is to introduce and discuss a model of rational trade
in which investors employ private information in anticipation of and in conjunc-
tion with a public announcement. We refer to the former as pre-announcement
information and the latter as event-period information. Pre-announcement
information is information that is used in advance of an announcement, in some
pre-announcement trading period. Provided that the pre-announcement
* Corresponding author. Tel.: (215) 898-6979; fax: (215) 573-2054; e-mail: verrecchia@whar-
ton.upenn.edu.
0165-4101/97/$17.00 ( 1997 Elsevier Science B.V. All rights reserved.

PII S 0 1 6 5 - 4 1 0 1 ( 9 8 ) 0 0 0 1 3 - 5
396 O. Kim, R.E. Verrecchia / Journal of Accounting and Economics 24 (1997) 395–419
information is not subsumed by the announcement itself, pre-announcement

information may also be employed after the announcement occurs. We define
event-period information to be information that can only be used in conjunction
with the announcement itself: in effect, only in the event-period. The motivation
for incorporating both pre-announcement and event-period information into
a single model is that it is more descriptive of real market settings. Common
sense suggests that only in rare circumstances does only one type of private
information exist. For example, all anticipated events or announcements moti-
vate pre-announcement private information gathering. In addition, event-period
private information is used in all announcements to provide a context or
interpretation to the disclosure. Consequently, event-period information also
seems a pervasive feature of disclosure.
Characterizing investors’ use of information both in anticipation of and in
conjunction with public announcements is a challenging problem in the context
of a rational model of trade. One prior attempt can be found in Dontoh and
Ronen (1993). Unfortunately, their analysis contains a conceptual error that
vitiates their results.1 More typically, models of trade eschew this issue entirely
by assuming that investors employ information either in anticipation of or in
conjunction with public announcements. Examples of papers whose analyses
are based exclusively on information in anticipation of an announcement
include: Kim and Verrecchia (1991a,b), Demski and Feltham (1994), McNichols
and Trueman (1994), and Abarbanell et al. (1995). Examples of papers whose
analyses are based on information in conjunction with the announcement
include: Varian (1989), Holthausen and Verrecchia (1990), Indjejikian (1991),
Harris and Raviv (1993), and Kim and Verrecchia (1994).
In addition to being less rich as a description of real markets, models based
exclusively on one type of information yield incomplete empirical implications
involving price change and volume relations. To demonstrate this point, we
introduce a general model with pre-announcement and event-period informa-
tion, and then derive as polar cases characterizations of trading volume based
exclusively on one feature. Then we show that when there exists exclusively
pre-announcement private information, expected trading volume has a linear
relation to absolute value price change, with a zero intercept. As discussed in
more detail below, this relation has been criticized by Kandel and Pearson
(1995), who show that empirically volume arises without price change. Similarly,
we show when there exists exclusively event-period private information, ex-
pected trading volume is independent of the absolute value of price change. This
result is contrary to the positive association between trading volume and
1 This error is discussed at the end of Section 2 of this paper.

O. Kim, R.E. Verrecchia / Journal of Accounting and Economics 24 (1997) 395–419 397
absolute value price change documented throughout the empirical literature

(e.g., Karpoff, 1986; Atiase and Bamber, 1994). A model that incorporates both
pre-announcement and event-period information eliminates empirical mis-
specifications that arise when only one feature is present.
As an application of our model, we show how trading volume can be
decomposed into pre-announcement and event-period effects. To achieve this,
we restrict our discussion to the case in which the quality of investors’ private
information remains fixed (relative to the market average) in the pre-announce-
ment and event periods, save for a proportionality parameter. Using this
assumption, we show how proxies for investors’ differential informedness in the
pre-announcement and event periods can be inferred from an estimation model
involving price changes.
One issue to address before starting the analysis is why pre-announcement
and event-period information effects have economic consequences. One part of
a firm’s cost of capital is thought to be the information asymmetry component:
that is, the cost arising from adverse selection in the purchase and sale of firm
shares in the presence of better informed traders. The conventional wisdom is
that disclosure reduces the cost of capital by substituting a public announce-
ment for private, pre-announcement information (see, e.g., Diamond and Ver-
recchia, 1991). However, this wisdom may only have universal application in an
environment in which only pre-announcement information exists. To the extent
there also exists event-period private information, disclosure may actually
increase the cost of capital, at least temporarily around the time of an announce-
ment.2 Therefore, distinguishing pre-announcement effects from event-period
effects, and perhaps even separating them out empirically, furthers our under-
standing of how disclosure affects the cost of capital. This, in turn, links
disclosure alternatives to economic benefits.
An outline of our paper is as follows. In Section 2 we introduce the assump-
tions underlying our model of rational trade, and derive and discuss the
resulting equilibrium. In Section 3 we characterize price change and expected
trading volume in terms of primitive elements of the model. As discussed above,
the focus of our attention here is to understand how our model eliminates
potential empirical misspecifications that are present in models based exclus-
ively on either information in anticipation of, or in conjunction with, announce-
ments. In Section 4 we discuss the possibility of applying our model to estimate
differential informedness in the pre-announcement and event periods. In a final
section we briefly summarize our discussion.
2 In a similar vein, Ball and Kothari (1991) hypothesize that beta risk increases during announce-
ment periods, but find limited evidence of significant changes.
2. The model and market equilibrium
We begin by taking the rational expectations trading model suggested in

Kim and Verrecchia (1991a), which is based on the existence of pre-announce-
ment private information, and adapting it to include event-period private
information of the type suggested in Kim and Verrecchia (1994). As rational
expectations models are well established in the literature, we will be very
succinct in describing the assumptions underlying this analysis. There are three
points in time, time 1, 2 and 3, and two assets in the economy, a risky asset (firm)
and a riskless bond. One unit of riskless bond pays off one unit of consumption
good at time 3 when consumption occurs. One unit of risky asset pays off u
units of consumption good at time 3. The random variable u is assumed to be
normally distributed with mean uN and precision (i.e., the reciprocal of variance)
h. There is a countably infinite number of informed investors in the economy
with constant but differing risk aversion and also a countably infinite number
of liquidity traders. That is, investor i’s utility function can be written as
a negative exponential utility function, º (¼ )"!exp(!(¼ /r )), where ¼ is
i i i i i
his wealth at time 3 and r is his risk tolerance; r is allowed to differ across
i i
investors.
In our model, time 1 characterizes the pre-announcement period. Four events
occur during the pre-announcement period. First, investor i, i"1,2,3,2, is
endowed with E riskless bonds and zero risky asset. Second, investor i observes
i
a private assessment of firm value, z "u#e , where e is independently and
1i 1i 1i
normally distributed with mean 0 and precision s . The s ’s may differ across
1i 1i
investors. Third, investor i obtains and observes private information about the
error in a forthcoming public announcement, which we assume to be an
earnings announcement. This information is represented by O "g!e , where
i 2i
the forthcoming earnings announcement is y"u#g. As discussed below,
O "g!e is used only at time 2 (in the event-period) in conjunction with
i 2i
earnings, y"u#g. Thus, investors’ actions and equilibrium are unaffected by
whether O is assumed to be observed at times 1 or 2. Note that we assume that
i
g and the e ’s are all independently and normally distributed with mean 0 and
2i
precisions n and s ’s, respectively. The s ’s may also differ across investors.
2i 2i
Fourth, the market opens and investors and liquidity traders buy and sell
securities at competitive market prices. The aggregate gross demand for the
risky asset by liquidity traders at time 1, denoted by x , is a random variable
1
normally distributed with mean 0 and precision t .
1
Time 2 characterizes the event-period. During the event-period there is
a public earnings announcement. As mentioned above, the earnings announce-
ment communicates firm value with noise, that is y"u#g. Here, the market
reopens and investors and liquidity traders exchange securities a second time.
The aggregate gross demand for the risky asset by liquidity traders at time 2,
denoted by x , is a random variable that is independently and normally
2
distributed with mean 0 and precision t . Finally, at time 3 the risky payoff u is
2
realized and investors consume their wealth.
Our model incorporates pre-announcement and event-period private in-
formation as follows. The z ’s provide private information about firm value at
1i
time 1, in the pre-announcement period. This is information investors can use to
revise their portfolios in the pre-announcement period in anticipation of a forth-
coming public announcement in period 2. A polar case of pre-announcement
information is information about the earnings announcement itself: that is,
z "y#e . In this circumstance the earnings announcement substitutes for
1i 1i
pre-announcement, private information, as the z ’s are redundant in the pres-
1i
ence of the earnings announcement y. While there is no problem using this as
a characterization of pre-announcement information, it has the conceptual
disadvantage that pre-announcement information becomes irrelevant after the
announcement occurs. Alternatively, in our model, because the public an-
nouncement does not perfectly substitute for the z ’s, they continue to play
1i
a role beyond the pre-announcement period.
With regard to event-period private information, the O ’s alone are not
i
informative about the firm’s liquidating value u. Thus, the O ’s cannot be used at
i
time 1, in the pre-announcement period. However, once earnings are announced
and y is known, the O ’s generate private information about firm value in the
i
form of z ,y!O "u#e . This information, in turn, is used by investor i to
2i i 2i
assess firm value. Institutionally, O can be thought of as the information an
i
investor gleans by studying the error in a firm’s financial reports, where the error
arises from the application of random, liberal, or conservative accrual-based
accounting practices and estimates.3 When earnings are announced, this in-
formation can then be used to partially correct for the error in an earnings
report.
A salient feature of our characterization of event-period private information is
that interpretations of the earnings announcement will be differential across
investors. As a practical matter, there is no way to distinguish whether differen-
tial interpretations of an announcement result explicitly from event-period
information or different likelihood functions arising from other sources. We
assume that differential interpretations arise from event-period information
(and a common likelihood function) in an attempt to draw a distinction between
effects on price change and volume that arise from pre-announcement phe-
nomena versus event-period phenomena. Kandel and Pearson (1995) assume
that differential interpretations arise from different likelihood functions among
3 This characterization assumes that earnings provide an unbiased estimate of value. To the extent
earnings are biased, investors would extract, or control for, this bias because they have ‘rational
expectations’.
investors to explore the consequences of this on price change and volume, both
for a model in which traders are naive and one in which they are fully informed.
However, their discussion of the latter is brief, and thus part of the motivation
for this paper is to expand on this idea.4
The analysis required to obtain an equilibrium in this model is standard and
is presented in Appendix A. Here, we simply describe market equilibrium and
discuss its implications. First, note that there exists a unique market equilibrium
in which: (1) investors choose their demand for securities to maximize their
utility based on their available information and (common) conjectures about the
(linear) relations between prices and aggregate information available at times
1 and 2; (2) markets clear at times 1 and 2; and (3) investors’ price conjectures are
fulfilled.
We use the averaging operator Avr[ ) ],lim (1/N)+N[ ) ] to define
N?= 1
r,Avr[r ], s ,Avr[s ], s ,Avr[s ]
i 1 1i 2 2i
in describing the equilibrium. We first describe the available information and
expectations of investors at times 1 and 2, i.e., before and after the earnings
announcement. At time 1 investor i has three sources of information. He has
prior knowledge about the risky asset’s payoff (the firm’s future prospect), as
represented by uN where uN has precision (quality) h. He also observes a private
assessment, z , of firm value contaminated with noise, e , with precision s .
1i 1i 1i
Finally, he observes price, denoted by P . By the self-fulfilling property of
1
expectations in a rational expectations equilibrium, P provides information
1
that can be represented by a normalized price signal
x
q ,u# 1
1 rs
1
with precision r2s2t (see Appendix A for detail). The information represented by
11
q is investor i’s inference from observing P , in addition to other available
1 1
information, uN and z . Price at time 1 is informative (even in the presence of
1i
uN and z ) because investors use their private information in choosing their
1i
demand, and thus price impounds this private information. The expression
r2s2t is intuitive. It is increasing in s , the average precision of private informa-
11 1
tion at time 1 across investors. It is increasing in r, the average risk tolerance of
investors, because more risk tolerance (less risk aversion) implies more aggres-
sive use of private information by investors, and thus price impounds private
information to a greater extent. It is also increasing in t , the precision of
1
liquidity demand at time 1, because a greater t implies less noise in price and
1
thus investors can extract more information from price.
4 Their analysis of the fully informed case is in footnote 8 of their paper.

The three sources of information are combined to form an investor’s expecta-

tion about the risky payoff. This can be seen by the total precision of investor i at
time 1, denoted by K :
1i
K ,Var~1[uDz ,P ]"h#s #r2s2t . (1)
1i 1i 1 1i 11
His expectation of the risky payoff, denoted by k , is
1i
huN #s z #r2s2t q
k ,E[uDz ,P ]" 1i 1i 1 1 1, (2)
1i 1i 1 h#s #r2s2t
1i 11
which is a weighted average of the three sources of information using their
respective precisions as weights.
There are three additional sources of information at time 2, immediately after
the earnings announcement. First, the earnings announcement itself communic-
ates y with precision n. Second, the differential interpretation of earnings
generates private information with precision s . Finally, the information im-
2i
pounded in price at time 2, P , can be represented by a normalized signal
2
x
q ,u# 2 ,
2 r(s #s )
1 2
with precision r2(s #s )2t . The quality of information conveyed by q is
1 2 2 2
increasing in s #s because both z and z are impounded in P . Note that
1 2 1i 2i 2
private information at time 1, the z ’s, is impounded in both P and P . Since
1i 1 2
the liquidity demands at times 1 and 2, i.e., x and x , are independent of each
1 2
other, the precisions of q and q each contribute to the total precision as shown
1 2
below.
The six sources of information available at time 2 are combined to generate
K ,Var~1[uDz ,P ,y,z ,P ]
2i 1i 1 2i 2
"h#s #r2s2t #n#s #r2(s #s )2t , (3)
1i 11 2i 1 2 2
and
k ,E[uDz ,P ,y,z ,P ]
2i 1i 1 2i 2
1
" [huN #s z #r2s2t q #ny#s z #r2(s #s )2t q ]. (4)
K 1i 1i 11 1 2i 2i 1 2 2 2
2i
The total precision at time 2 is the sum of the precisions of the six independent
sources and the expected risky payoff is a weighted average of the six using
precision as weights.
We now turn to the price of the risky asset. Price arises such that securities
markets clear. Thus, equilibrium prices reflect individual demand choices,
which, in turn, reflect investors’ information. Price at time 2, i.e., P , is

2
1
P " [huN #r2s2t q #ny#Ms #s #r2(s #s )2t Nq ], (5)
2 K 11 1 1 2 1 2 2 2
2
where
K ,Avr[K ]"h#s #r2s2t #n#s #r2(s #s )2t
2 2i 1 11 2 1 2 2
is the average total precision at time 2. The similarity between Eqs. (4) and (5)
suggests that price at time 2 roughly reflects the average beliefs of investors at
time 2. The term (s #s )q is obtained in Eq. (5) (compared to s z #s z in
1 2 2 1i 1i 2i 2i
Eq. (4)) because investors’ private information, the z ’s and z ’s, is impounded
1i 2i
in P without idiosyncratic error terms. The error terms (i.e., the e ’s and e ’s)
2 1i 2i
disappear because they are independent and hence are diversified away in the
aggregation process: the information is conveyed with market noise (liquidity
demand) instead.
Price at time 1, i.e., P can be expressed as
1,
1 hs (K !s )
P " [huN #(s #r2s2t )q ]! 1 1 1 (q !uN ),
1 K 1 11 1 K MK (K #s #r~2t~1)#s2N 1
1 1 1 2 2 2 1
(6)
where
K ,Avr[K ]"h#s #r2s2t
1 1i 1 11
is the average total precision at time 1. Eq. (6) is interesting. The first, square-
bracket term reflects the average beliefs of investors at time 1, similar to Eq. (5).
The presence of the second term is due to the fact that investors expect to buy or
sell securities at time 2 at a price P . Note from Eq. (5) that the expression for
2
P contains uN and q , which are estimates of u. While the errors in uN and q , i.e.,
2 1 1
uN !u and q !u, are contained in P , the errors in the z ’s, i.e., the e ’s, are
1 2 1i 1i
diversified away in P . For this reason investors place extra weights on uN and
2
q (in addition to their respective precisions, i.e., in addition to the weights that
1
appear in the first term) when investors choose their demand at time 1. As
a result, the weight on uN is positive in the second term. On the other hand, the
total weight on q in P is determined by the weights placed by investors on
1 2
q and those on z ’s, because idiosyncratic noise in z ’s is diversified away and
1 1i 1i
the information is conveyed with market noise. The extra negative weights on
z ’s and the extra positive weights on q (in addition to the weights shown in the
1i 1
first term) sum up to a negative extra weight on q , as shown in the second term
1
of Eq. (6).
Given the equilibrium prices at times 1 and 2, the individual (gross) demand
for the risky asset, denoted by D and D , can be expressed as (proof in
1i 2i
Appendix A)
D "r [(s z !s q )!(K !K )P ] (7)
1i i 1i 1i 1 1 1i 1 1
and
D "r [(s z #s z !(s #s )q )!(K !K )P ], (8)
2i i 1i 1i 2i 2i 1 2 2 2i 2 2
where K !K "s !s , and K !K "(s !s )#(s !s ). Eqs. (7) and
1i 1 1i 1 2i 2 1i 1 2i 2
(8) are intuitive and evidence the same strategy at both times 1 and 2. First,
individual gross demand (equilibrium holding) is proportional to the investor’s
risk tolerance. Second, individual demand has two additive components. The
two components arise from the fact that an individual investor’s belief and the
market price reflect different information, and also reflect the same information
with different weights. The first component (in parenthesis) represents the
trading incentive arising from the fact that the investor uses his private informa-
tion, while the market price conveys the aggregate private information with
liquidity noise. Note that the weights are also averaged (from s to s and from
1i 1
s to s ) in the aggregation process. The second component arises from the
2i 2
differential sensitivity to price among investors due to differential precision.
A better informed investor exploits his market opportunity more aggressively
than a poorly informed investor. This term vanishes if there is no differential
precision: that is, if investors are equally well informed.
Dontoh and Ronen (1993) (DR) study a multi-period trading problem that is
similar to the one outlined in this section. The only significant distinctions
between their model and the one here are that they assume that investors’
private information precisions are identical (i.e., s ,s and s ,s for all i),
1i 1 2i 2
and there exists a common error term in investors’ private assessments of firm
value at time 1 (e.g., z "u#H#e , where H represents some common error
1i 1i
in investors’ private information).5 The conceptual error in DR can be explained
as follows. As in our paper, in DR the information set for investor i at time 2 is
Mz ,P ,y,O ,P N (or, equivalently, Mz ,P ,y,z ,P N). However, in place of y and
1i 1 i 2 1i 1 2i 2
O , DR assume that the information set for investor i is Mz ,P ,y ,P N, where
i 1i 1 2i 2
y is a linear amalgamation of y and O .6 The error that results from using y in
2i i 2i
place of y and O is that the information set Mz ,P ,y ,P N does not yield the
i 1i 1 2i 2
same expectation as Mz ,P ,y,O ,P N when P is correlated with y and/or
1i 1 i 2 2
O conditional on u, which is the case (as demonstrated in Eq. [5]).
i
5 Dontoh and Ronen (1993) also assume that all investors have identical risk tolerances (i.e., r ,r
i
for all i), but this assumption has limited significance in that it does not affect the underlying
information structure.
6 Specifially, see the discussion in footnote 6 of their paper. For example, using the notation in
their paper, Dontoh and Ronen (1993) characterize the amalgamated observation as
y 2"y#m "y#(1!d)l#dn .
i i i
3. Price change and volume
In this section we examine price change and volume at the time of the earnings
announcement (i.e., in the event period). Using Eqs. (5) and (6), we can express
event-period price change in the following way:
C D
K !K ny#s u#r2(s #s )2t q huN #s u#r2s2t q
P !P " 2 1 2 1 2 2 2! 1 11 1
2 1 K n#s #r2(s #s )2t h#s #r2s2t
2 2 1 2 2 1 11
A B
x x hs (K !s )
# 2! 1 # 1 1 1 (q !uN ).
rK rK K MK (K #s #r~2t~1)#s2N 1
2 1 1 1 2 2 2 1
(9)
In Eq. (9) the second term in parenthesis represents liquidity noise, and the third
term follows from Eq. (6) and its interpretation. The first, square-bracketed term
in Eq. (9) is the surprise in the ‘new’ information provided by the announcement,
and contains two expressions. The first expression is a summary measure of the
new information made available at time 2. Specifically, it is a weighted average
(the weights being the contribution of the new information to the individual
precision divided by the same to the average precision) of the information made
available at time 2 to individual investors. The second expression is the market’s
estimate of the new information that becomes available at time 2 based on the
available information at time 1, i.e., the estimates of the first expression. Specifi-
cally, it is a weighted average (the weights being the ratio of the individual
precision to the average precision at time 1) of individual estimates of the first
term. Taken together, the two expressions in square-brackets represent the
surprise in new information at time 2, y, z , and q .
2i 2
The multiple attached to the square-bracket, i.e., (K !K )/K , corresponds
2 1 2
to the response coefficient to the new information. It is the percentage of the new
information relative to the total available information at time 2, expressed as
a percentage of total information at time 2. A problem in relating Eq. (9) to the
earnings response coefficient is that private interpretations (z ’s in this model)
2i
or price information gleaned from price based on private information (q in this
2
model) may not be readily available to an empirical researcher. For this reason
Eq. (9) can be rewritten as
C D
n huN #s u#r2s2t q
P !P " y! 1 11 1
2 1 K h#s #r2s2t
2 1 11
C D
s #r2(s #s )2t s u#r2(s #s )2t q huN #s u#r2s2t q
#2 1 2 2 2 1 2 2 2! 1 11 1
K s #r2(s #s )2t h#s #r2s2t
2 2 1 2 2 1 11
A B
x x hs (K !s )
# 2! 1 # 1 1 1 (q !uN ). (10)
rK rK K MK (K #s #r~2t~1)#s2N 1
2 1 1 1 2 2 2 1
In Eq. (10) the square-bracketed term in Eq. (9) is divided into two terms. If y is
interpreted as the earnings released at time 2, the multiple attached to the first
square-bracketed term, i.e., n/K , corresponds to the earnings response coeffic-
2
ient.7 The inside of the second square-bracket is the surprise in z ’s and q , and
2i 2
may not be observed by a researcher.
We now turn to per-capita trading volume.8 The next proposition is obtained
from Eqs. (7) and (8).
Proposition 1. Per-capita trading volume at the time of the earnings announcement

can be written as »olume"1Avr[DD !D D], where
2 2i 1i
D !D "
2i 1i
C D
x !x
r 1 2#s e #(s !s )(P !P )#(s !s )(u!P ) . (11)
i r 2i 2i 1i 1 1 2 2i 2 2
Proposition 1 shows that the magnitude of trading volume depends on the

aggregate absolute value of the sum of the four terms inside the square-bracket
in Eq. (11). These terms are: (x !x )/r, s e , (s !s )(P !P ), and
1 2 2i 2i 1i 1 1 2
(s !s )(u!P ), respectively. By way of explaining the general expression in
2i 2 2
Eq. (11), we introduce some polar cases through the following corollaries.
The focus of these polar cases is to understand Proposition 1 in the context of
extant empirical work. To facilitate this discussion, hereafter we assume that the
liquidity shocks at times 1 and 2 are approximately equal: that is, x !x +0.
1 2
The basis for this assumption is that an empirical study of price changes and
volume would likely control for effects arising from non-information motivated
trade, which is precisely what x and x capture. Consequently, it seems
1 2
appropriate to control for these effects in our discussion by setting x and
1
x equal. Employing this assumption, Eq. (11) can be rewritten as
2
D !D "r [s e #(s !s )(P !P )#(s !s )(u!P )]. (12)
2i 1i i 2i 2i 1i 1 1 2 2i 2 2
The first polar case of interest is one in which there is no event-period private
information: that is, s "0, for all i.
2i
7 This assumes that, in an empirical context, one adequately controls for the other terms in
Eq. (10) that are correlated with the first term. Otherwise, n/K may not correspond to the earnings
2
response coefficient.
8 The (noisy) rational expectations paradigm assumes a countably infinite number of informed
traders, to ensure perfect competition. Consequently, the convention in the rational expectations
literature is to analyze per-capita volume, and not total volume. Henceforth, when we use the
expressions ‘volume’ or ‘trading volume’, we mean the per-capita trading volume of informed
traders.
Corollary 1. ¼hen there exists no event-period private information

(i.e., s "0), the change in individual demand becomes
2i
D !D "r (s !s )(P !P ).
2i 1i i 1i 1 1 2
Corollary 1 follows from Eq. (12) and the fact that the first and third terms
vanish because in the absence of event-period private information, s "s "0.
2i 2
Consequently, the only term that remains in the square-bracket is
(s !s )(P !P ). This term arises because investors with pre-announcement
1i 1 1 2
private information of differing quality (i.e., different s ’s) react differently to the
1i
earnings announcement. In particular, the change in an individual investor’s
demand is positively (negatively) correlated with the change in price (P !P )
2 1
when the investor is relatively poorly (better) informed (i.e., positively correlated
when s (s , and negatively when s 's ). Thus, the implication of corollary
1i 1 1i 1
1 is that of Kim and Verrecchia (1991a). Specifically, trading volume at the time
of an earnings announcement is
1
Volume" Avr[r Ds !s D]DP !P D. (13)
2 i 1i 1 1 2
This result implies that trading volume is related positively to both the absolute
value price change and the degree of differential informedness in the pre-
announcement information period.
When the precisions of pre-announcement, private information (i.e., the s ’s)
1i
are identical, the entire expression in corollary 1 goes to zero. This implies
that no trade occurs at the earnings announcement. In the event that
liquidity shocks at times 1 and 2 are different, i.e., x !x O0, then from
1 2
r
i
Eq. (11) D !D " (x !x ), and here informed investors simply absorb
2i 1i r 1 2
fractions (proportional to their risk tolerance) of the change in liquidity demand.
Milgrom and Stokey (1982) show that trade occurs if either the market is not
fully allocationally efficient and/or if beliefs are not concordant. When s "s ,
1i 1
volume is zero because the market is allocationally efficient and beliefs are
concordant. When s Os , trade occurs because the market is not allocationally
1i 1
efficient while beliefs remain concordant.
The potential empirical misspecification that arises when event-period private
information is ignored is that the change in demand, and hence volume, is linear
in price change with a zero intercept (assuming x "x ): that is, Corollary
1 2
1 implies D !D "r (s !s )(P !P ). The economic intuition underlying
2i 1i i 1i 1 1 2
this relation is that investors with higher quality pre-announcement private
information, relative to the market as a whole (i.e., s !s '0), are better
1i 1
informed and thus act like market makers. That is, if the earnings announcement
is ‘good news’ (i.e., P !P '0), then it is more profitable for them to supply
2 1
liquidity (i.e., sell or short-sell firm shares) on the news to less well informed
investors. Alternatively, if the information is ‘bad news’ (i.e., P !P (0), it is

2 1
more profitable for them to absorb liquidity (i.e., go long in firm shares) on the
news. Nevertheless, the relation D !D "r (s !s )(P !P ) implies that
2i 1i i 1i 1 1 2
trading volume can only arise from a change in price. In examining the validity
of this relation empirically, Kandel and Pearson (1995) document significant
abnormal volume even when the announcement period return is zero, or close to
zero. Consequently, they conclude that the relation in Eq. (13) is misspecified
because it suggests no volume in the absence of price changes. In their discussion
of possible explanations for this misspecification, Kandel and Pearson (1995)
call into question the assumption that public announcements are interpreted
commonly across investors, as opposed to differentially.
Event-period private information is one explanation for how volume can arise
in the absence of price change. To see this, in the next corollary we introduce
event-period private information, but for the case in which the precisions of the
private information are identical across investors: that is, s "s , for all i.
2i 2
Corollary 2. ¼hen there exists event-period private information of identical
quality, (i.e., s "s '0), the change in individual demand becomes
2i 2
D !D "r [s e #(s !s )(P !P )].
2i 1i i 2 2i 1i 1 1 2
Compared to Corollary 1, here there is an additional term, s e . Thus, trade
2 2i
occurs due to differential interpretation of earnings through event-period in-
formation (thus, nonconcordant beliefs) even if s "s and the market is
1i 1
allocationally efficient. The variable s is the degree of confidence that investor
2i
i places in his idiosyncratic interpretation of earnings. When s "s , the
2i 2
variance of the term s e is s , and s e is independent of other terms. Therefore,
2 2i 2 2 2i
volume at the time of an earnings announcement is positively related to
absolute-value price change, pre-announcement differential informedness (i.e.,
Avr[r Ds !s D]), and event-period private information through s . In short,
i 1i 1 2
event-period information ensures volume even in the absence of price change.
Corollary 2 is also consistent with a recent finding by Barron (1995) and
Bamber et al. (1996) that trading volume at the time of earnings announcements
is positively related to the degree of ‘belief jumbling’ among analysts, after
controlling for the absolute-value price change. Their proxy for the degree of
belief jumbling is one minus the sample correlation of earnings forecasts, before
and after the earnings announcement. To the extent forecast dispersion among
analysts is caused by differential interpretation of earnings, this proxy should be
positively correlated with s , our measure of the average amount of event-period
2
private information.
The second polar case is one in which there exists no pre-announcement
private information: that is, s "0, for all i. When investors have different
1i
expectations of firm value in the pre-announcement period, they use time 1 as an
opportunity to resolve their disagreements and ensure themselves against the
consequences of the public announcement at time 2. When there exists no

pre-announcement private information at time 1, there can be no disagreement
among investors. Hence, investors do not trade at that time. Consequently,
s "0 for all i may seem on the surface an uninteresting case. Nonetheless, it is
1i
worth pointing out that here the change in demand at time 2, and hence volume,
is independent of absolute value change in price, DP !P D.
2 1
Corollary 3. ¼hen there exists no pre-announcement, private information (i.e.,
s "s "0) or private information of identical quality (i.e., s "s '0), the
1i 1 1i 1
change in individual demand becomes
D !D "r [s e #(s !s )(u!P )].
2i 1i i 2i 2i 2 2i 2
In this case demand is not directly related to price change, and trading volume
is not directly related to absolute value price change. This result, however, is
contrary to a host of empirical studies that document the positive association
between volume and absolute value price change (see, e.g., Karpoff, 1986; Atiase
and Bamber, 1994). Thus, ignoring pre-announcement private information
yields a potential empirical misspecification.
Note that combining corollaries 2 and 3 implies that when pre-announcement
and event-period private information are of identical quality, (i.e., s "s '0
1i 1
and s "s '0) the change in demand reduces here to
2i 2
D !D "r s e .
2i 1i i 2 2i
In effect, event-period private information ensures trading volume even in the
presence of identical quality private information (or no pre-announcement
private information).
4. Empirical considerations
In this section we attempt to determine proxies for investors’ differential

informedness in the pre-announcement and event periods, 1Avr[r Ds !s D] and
2 i 1i 1
1Avr[r Ds !s D], respectively. Our interest in proxies for differential informed-
2 i 2i 2
ness is motivated by the observation that different firms provide accounting
information of varying quality, disclose different kinds of information in addi-
tion to earnings announcements, are followed by different numbers of analysts
and investors of varying ability, etc. This suggests that one should expect
pre-announcement and event-period private information to vary cross-section-
ally. For example, anticipated announcements, like earnings announcements,
arguably have a relatively higher pre-announcement component than unan-
ticipated announcements, like the announcement of a business combination.
This is because, in the case of the former, there exists more pre-announcement
information about earnings through analysts, and management forecasts.
Alternatively, in the case of the latter, there may only exist event-period informa-
tion because business combinations are likely to be wholly unanticipated. If
there exist cross-sectional differences in investors’ pre-announcement and
event-period information, these differences should manifest themselves as differ-
ences in the relation between price changes and trading volume.
When the general expression for trading volume developed previously in the
paper is employed, estimating differential informedness is bedeviled by a variety
of problems. To appreciate these problems, consider the general expression for
trading volume with both pre-announcement and event-period information of
differential quality. Eq. (12) implies that in the general case, (per-capita) volume
is
Volume"1Avr[r Ds e #(s !s )(u!P )#(s !s )(P !P )D], (14)
2 i 2i 2i 2i 2 2 1i 1 1 2
where r , s , s , s , and s are (fixed) exogenous parameters related to the risk
i 1i 2i 1 2
and informedness of individual investors, while e , P , P , and u are random
2i 1 2
variables. The primary difficulty with applying Eq. (14) to estimate differential
informedness is that it is an expression based on the absolute value of sums, and
not the sum of absolute values. An initial step that makes this expression more
facile is to note that e is unobservable to a researcher. Furthermore, taking the
2i
expectation of Eq. (14) with respect to e (and holding u, P , and P fixed) yields:
2i 2 1
E[VolumeDu,P ,P ]
2 1
"1Avr[r D(s !s )(u!P )#(s !s )(P !P )D]#Avr[r R ], (15)
2 i 2i 2 2 1i 1 1 2 i i
where R is defined by
i
P
~@ki@
R" F (w) dw,
i i
~=
where k ,(s !s )(u!P )#(s !s )(P !P ), and F is the cumulative
i 2i 2 2 1i 1 1 2 i
density function of a normally distributed random variable with mean 0 and
variance s .9
2i
The expression R is a ‘residual’ term. It is always positive, and achieves its
i
maximum value of Js /2n when k "0. However, R decreases as Dk D increases,
2i i i i
and approaches 0 as Dk D becomes large. In addition, it can be shown that for
i
fixed k , R increases as s increases. We discuss the significance of R in an
i i 2i i
empirical context below.
9 More generally, if e is a mean 0, normally distributed random variable with cumulative density
function F, and k some fixed constant, it can be shown that
P
~@k@
E[De#kD]"DkD#2 F(w) dw.
~=
The significance of Eq. (15) is that it can be employed to determine proxies for
differential informedness in special cases. For example, consider the case dis-
cussed in Kandel and Pearson (1995) in which volume arises in the absence of
price changes. This case is tantamount to conditioning over situations where
P "P , which, in turn, reduces Eq. (15) to
1 2
1
E[Volume D u,P ,P ]" Avr[r Ds !s D]Du!P D#Avr[r R ]. (16)
2 1 2 i 2i 2 2 i i
By yielding an expression that is the sum of absolute values, Eq. (16) lends itself
to estimation of differential informedness in the event period,
1Avr[r Ds !s D]. Eq. (16) also results from the special case of low, a% priori
2 i 2i 2
pre-announcement information, because here s ,0. Low, a% prior pre-an-
1i
nouncement information could describe possibly a situation in which an an-
nouncement was wholly unanticipated, such as the announcement of a business
combination. This case also lends itself to estimation of differential informedness
in the event period. Alternatively, consider the special cases of either little
change in price in the post-announcement period, i.e., P "u, or an announce-
2
ment for which there is low, a% priori event-period differential informedness, i.e.,
s ,0, for all i. The former could describe a situation in which there was no
2i
change in price after the announcement, and the latter a situation in which the
announcement did not lend itself to differential interpretations, like, possibly,
a macroeconomic event (e.g., the announcement of a change in interest rates). In
these cases Eq. (15) reduces to
1
E[VolumeDu,P ,P ]" Avr[r Ds !s D]DP !P D#Avr[r R ], (17)
2 1 2 i 1i 1 1 2 i i
where, in addition, Avr[r R ],0 whenever it is assumed that s ,0, for all i.
i i 2i
These special cases lend themselves to estimation of differential informedness in
the pre-announcement period, 1Avr[r Ds !s D].
2 i 1i 1
While these special cases are of interest and may ultimately prove the most
useful in determining proxies for investors’ differential informedness, the general
case also warrants some discussion. To render the general case amenable to
empirical analysis, it is necessary to introduce the following simplifying assump-
tion. For each investor i, assume that the ratio of his relative informedness in the
event and pre-announcement periods is a fixed, positive parameter h, which is
independent of i: that is
s !s
2i 2,h.
s !s
1i 1
This assumption is equivalent to asserting that the quality of an investor’s
private information, relative to the market average, remains fixed across inves-
tors in the pre-announcement and event periods, save for a proportionality
factor. Under this assumption, the parameter h is the ratio of investors’ differen-
tial informedness in the event period relative to the pre-announcement period.
Allowing for the fact that s !s ,h(s !s ) for all i implies that the general
2i 2 1i 1
expression for trading volume, Eq. (15), can be reduced to
E[Volume D u,P ,P ]
2 1
"1Avr[r Ds !s D](Dh(u!P )#P !P D)#Avr[r R ]. (18)
2 i 1i 1 2 1 2 i i
Eq. (18) requires further refinement because it continues to contain an expres-
sion, Dh(u!P )#P !P D, that is the absolute value of sums. To reinterpret
2 1 2
this expression as the sum of absolute values, assume that u, P , and P are all
2 1
known (recall that these variables reflect security prices at specific times), and
assign some value h . Then, note that when u!P and P !P are of the same
2 1 2
sign, Dh(u!P )#P !P D"hDu!P D#DP !P D. However, when they are of
2 1 2 2 1 2
opposite signs, Dh(u!P )#P !P D is equal to either hDu!P D!DP !P D or
2 1 2 2 1 2
!hDu!P D#DP !P D, depending upon whether hDu!P D*DP !P D or
2 1 2 2 1 2
hDu!P D(DP !P D. Through this device, the absolute value of a sum can be
2 1 2
effectively reduced to the sum of absolute values. More formally, consider the
operator X [ ) ], which is a function of an arbitrarily chosen h. For each u, P , P ,
h 2 1
and h, X [ ) ] takes a price change and reconstitutes it as either the absolute value
h
of the change, or minus the absolute value. It does it in the following way (there
are three cases to consider). When sgn[u!P ]"sgn[P !P ],
2 1 2
X [u!P ]"Du!P D and X [P !P ]"DP !P D
h 2 2 h 1 2 1 2
for all h. However, when sgn[u!P ]Osgn[P !P ], if hDu!P D*DP !P D,
2 1 2 2 1 2
then
X [u!P ]"Du!P D and X [P !P ]"!DP !P D;
h 2 2 h 1 2 1 2
and if hDu!P D(DP !P D, then
2 1 2
X [u!P ]"!Du!P D and X [P !P ]"DP !P D.
h 2 2 h 1 2 1 2
Employing X allows Eq. (18) to be rewritten as
h
1
E[VolumeDu,P ,P ]" Avr[r Ds !s D]hX [u!P ]
2 1 2 i 1i 1 h 2
1
# Avr[r Ds !s D]X [P !P ]#Avr[r R ]. (19)
2 i 1i 1 h 1 2 i i
The significance of Eq. (19) is that it effectively linearizes the original general
expression for volume in Eq. (14), conditional on u, P , P and a choice of h.
2 1
Specifically, Eq. (19) is suggestive of the following regression:
E[VolumeDu,P ,P ]"a#bX [u!P ]#cX [P !P ]#m, (20)
2 1 h 2 h 1 2
where a is an intercept term that proxies for the residual term Avr[r R ], b and
i i
c the coefficients associated with the change in prices, and m represents the
random error (i.e., ‘white noise’) in volume, which captures other factors
that affect volume not introduced in our model (and uncorrelated with
other random variables). In particular, in Eq. (20) b is a proxy for
1Avr[r Ds !s D]h,1Avr[r Ds !s D], which represents investors’ differential
2 i 1i 1 2 i 2i 2
informedness in the event-period, and c is a proxy for 1Avr[r Ds !s D], which
2 i 1i 1
represents differential informedness in the pre-announcement period.
How could one use Eq. (20) to estimate investors’ differential informedness in
the pre-announcement and event periods? The implementation of Eq. (20)
requires a series of steps. First, a researcher must conjecture an initial value for h.
Second, based on this initial value, a researcher would need to calculate
independent variables according to the rules laid out by the operator X . Third,
h
using these variables, the regression implied by Eq. (20) must be run to estimate
the coefficients b and c. Finally, a researcher would need to determine whether
the ratio of the estimated b to c approximates h, as this is a requirement for the
model to be consistent. This is a requirement because by assumption
b 1Avr [r Ds !s D]
"2 i 2i 2 "h.
c 1Avr[r D s !s D ]
2 i 1i 1
To the extent b/c does not approximate the conjectured h, a researcher should
employ the estimated b/c’s to update his or her conjecture about h, and then
start the process all over again. This iterative process can be terminated (and
said to converge) when there exists some conjectured hK , say, with the property
that the b/c ratio estimated on the basis of hK approximates that conjecture.
There is no guarantee that the process converges for every sample. Assuming
convergence, the corresponding c and b coefficients then serve as proxies for the
differential informedness of an investor in the pre-announcement and event
periods, 1Avr[r Ds !s D] and 1Avr[r Ds !s D] respectively.
2 i 1i 1 2 i 2i 2
Estimated b and c coefficients make it possible to test hypotheses that relate
information environments cross-sectionally to the quality of investors’ differen-
tial informedness in the pre-announcement and event periods. For example, one
would expect anticipated announcements, like earnings announcements, to have
a lower b/c ratio than unanticipated announcements, like business combina-
tions. While this type of cross-sectional variation story has appeal, its implemen-
tation depends on a host of factors that a researcher must account for in an
empirical study, such as differences in the pre-announcement information envi-
ronment, characteristics of the announcement, etc. Perhaps employing analysts’
earnings forecasts, as proposed by Abarbanell et al. (1995) and Barron et al.
(1996), would be helpful in tackling this issue.10
10 See Ziebart (1990), Barron (1995) and Bamber et al. (1996) for examples of such studies.
With regard to the residual term Avr[r R ] (and its proxy a), recall that it is
i i
a function of D(s !s )(u!P )#(s !s )(P !P )D, and approaches zero as
2i 2 2 1i 1 1 2
the latter expression becomes large for all i. The proxy for the latter expression
averaged over all i is bX [u!P ]#cX [P !P ]. Thus, in samples where
h 2 h 1 2
bX [u!P ]#cX [P !P ] is large (on average), the residual term should
h 2 h 1 2
create less estimation error, and the intercept term a should approximate zero.
In addition, recall that R and s are positively, monotonically related (holding
i 2i
D(s !s )(u!P )#(s !s )(P !P )D fixed). This suggests that a can be inter-
2i 2 2 1i 1 1 2
preted as a proxy for Avr[r s ], the average risk-adjusted precision of investors’
i 2i
event-period information, in samples where bX [u!P ]#cX [P !P ] re-
h 2 h 1 2
mains relatively stable (on average).
This discussion should not be interpreted as ignoring the difficulty of imple-
menting an estimation model of the type we describe. For example, implementa-
tion requires associating P , P and u with security prices at specific times, and
1 2
this is fraught with potential problems. The least controversial interpretation is
the one involving P , which represents the pre-announcement price of the firm.
1
Potentially more controversial is P , which represents the event-period price,
2
because this could be either the price at the end of the announcement day, at the
end of the day after the announcement, or later still depending upon investors’
ability to process earnings-announcement data and execute trades based on
their revised expectations. The most problematic is u, which is defined in our
model to be the liquidating value of the firm. A proxy for liquidating value could
be the post-announcement price of the firm. However, given post-announce-
ment drift, it would seem appropriate to measure u some considerable amount
of time after the announcement, such as the first quarter after the announce-
ment, or perhaps later.
5. Conclusion
In this analysis, we incorporate both pre-announcement and event-period

information into a single model of rational trade. A key implication of pre-
announcement information in our model is that demand change, and hence
trading volume, is related to price change at the time of an earnings announce-
ment. This implication is consistent with widespread evidence that trading
volume is positively associated with absolute value price change (see, e.g.,
Karpoff, 1986; Atiase and Bamber, 1994). A key implication of event-period
information in our model is that demand change, and hence trading volume,
occurs even in the absence of price change. This implication is consistent with
the claim that trading volume occurs even in the absence of price change
( Kandel and Pearson, 1995). In addition, there exists evidence that the informa-
tion asymmetry component of the bid—ask spread increases at the time of an
earnings announcement ( Krinsky and Lee, 1996), which is also consistent with
the existence of event-period information. Even in the absence of empirical

validation, common sense would seem to suggest that in most circumstances
public announcements have aspects of both features. Consequently, the motiva-
tion to incorporate both into a single model of trade should be self-evident.
Acknowledgements
The authors acknowledge helpful comments and suggestions from S.P. Ko-
thari (the editor), Andrew W. Alford, Robert W. Holthausen, workshop partici-
pants at Baruch College, and an anonymous referee.
Appendix A. Calculation of rational expectations equilibrium
Let the linear conjecture of P and P be written as

1 2
P "a uN #b Avr[z ]#c x
1 1 1 1i 1 1
"a uN #b u#c x , (A.1)
1 1 1 1
and
b
P "a uN #hy# 2[Avr[z ]#Avr[z ]]#c x #dq
2 2 2 1i 2i 2 2 1
"a uN #hy#b u#c x #dq , (A.2)
2 2 2 2 1
where
1 c
q , (P !a uN )"u#B x , B , 1 .
1 b 1 1 1 1 1 b
1 1
We also define
1 c
q , (P !a uN !hy!dq )"u#B x , B , 2.
2 b 2 2 1 2 2 2 b
2 2
Then,
huN #s z #(t /B2) q
k ,E[uDz ,P ]"E[uDz ,q ]" 1i 1i 1 1 1,
1i 1i 1 1i 1 h#s #(t /B2)
1i 1 1
t
K ,Var~1[uDz ,P ]"Var~1[uDz ,q ]"h#s # 1 ,
1i 1i 1 1i 1 1i B2
1
k ,E[uDz ,P ,y,z ,P ]
2i 1i 1 2i 2
"E[uDz ,q ,y,z ,q ]
1i 1 2i 2
huN #s z #(t /B2)q #ny#s z #(t /B2) q

" 1i 1i 1 1 1 2i 2i 2 2 2,
h#s #(t /B2)#n#s #(t /B2)
1i 1 1 2i 2 2
and
K ,Var~1[uDz ,P ,y,z ,P ]
2i 1i 1 2i 2
"Var~1[uDz ,q ,y,z ,q ]
1i 1 2i 2
t t
"h#s # 1 #n#s # 2 .
1i B2 2i B2
1 2
We also define the average total precision at times 1 and 2 by
t
K ,Avr[K ]"h#s # 1
1 1i 1 B2
1
and
t t
K ,Avr[K ]"h#s # 1 #n#s # 2 ,
2 2i 1 B2 2 B2
1 2
respectively, where
r,Avr[r ], s ,Avr[s ], s ,Avr[s ].
i 1 1i 2 2i
By the convenient properties of the normal distribution and the exponential
utility function, investor i’s demand at time 2 is
D "r K (k !P )
2i i 2i 2i 2
A B
t t
"r huN #s z # 1 q #ny#s z # 2 q !K P . (A.3)
i 1i 1i B2 1 2i 2i B2 2 2i 2
1 2
The market clearing condition gives
0"Avr[D ]#x
2i 2
A B
t t
"r huN #s u# 1 q #ny#s u# 2 q !K P #x . (A.4)
1 B2 1 2 B2 2 2 2 2
1 2
This can be rewritten as
C A B A BD
1 t t 1 t
P " huN # 1 q #ny# s #s # 2 u# # 2 x . (A.5)
2 K B2 1 1 2 B2 r B 2
2 1 2 2
Since Eq. (A.2) must be equivalent to Eq. (A.8), we have B "1/r(s #s ). The
2 1 2
above then can be rewritten as
1
P " [huN #r2s2t q #ny#Ms #s #r2(s #s )2t Nq ]. (A.6)
2 K 11 1 1 2 1 2 2 2
2
From Eqs. (A.3) and (A.6) we can rewrite D as

2i
D "r [(s z #s z !(s #s )q )!(K !K )P ]. (A.7)
2i i 1i 1i 2i 2i 1 2 2 2i 2 2
Investor i’s problem at time 1 is to
Max E[º (¼ )Dz ,P ]

i i 1i 1
D1i
"E[º (¼ )Dz ,q ]
i i 1i 1
C G HK D
1
"E !exp ! [E #(P !P )D #(u!P )D ] z ,q
r i 2 1 1i 2 2i 1i 1
i
C G HK D
E D K
"E !exp ! i#(P !P ) 1i! 2i(k !P )2 z ,q ,
r 1 2 r 2 2i 2 1i 1
i i
where the third equality follows from the law of iterated expectations. In order
to solve this problem, we now define two variables:
a,k !P , b,k .
2i 2 2i
It can be shown that the two random variables, a and b, span all the random
variables above (actually, the result of the integration verifies this). We can
calculate
s #s #r~2t~1 1 1 1 1
Var(a)" 1 2 2 # ! , Var(b)" ! ,
K2 K K h K
2 2 2i 2i
1 1 1
Cov(a,b)" ! , Cov(a,z )" , Cov(a,q )"0,
K K 1i K 1
2 2i 2
1
Cov(a,z )"Cov(b,q )" .
1i 1 h
By using the above we can calculate
s1i [!huN #(h# t21 )z ! t21 q ]
CA BK D A B
a
E z ,q " K1iK2 B 1 1i B 1 1
b 1i 1 1 [huN #s z # t21 q ]
K1i 1i 1i B 1 1
and
s2`r~2t~12`K1~K1i# s21i2 # 1 ! 1 1 ! 1 ! s1i
CA BK D A B
a
Var z ,q " K2 K1iK 2 K2 K2i K2 K2i K1iK2 .
b 1i 1 1 ! 1 ! s1i 1!1
K2 K2i K1iK2 K1i K2i
Also, the inverse of the above variance is
K K K2 1 ! 1 ! 1 # 1 # s1i
G A
1i 2i 2 K1i K2i
! 1 # 1 # s1i
K2 K2i K1iK2
K2 K2i K1iK2
s2`r~2t~12`K1~K1i# s21i2 # 1 ! 1
K2 K1iK 2 K2 K2i
,
B
where
G,(K !K )(s #r~2t~1)!s2#(s !s )(K !K #2s ).

2i 1i 2 1 2i 2 2 1 1
Therefore, the expected utility can be written as (omitting terms unrelated to
D )
1i
PP C G A B
1 D K2
! exp ! !2 1i (P #a!b)#K a2# 2 (K !K )
2 r 1 2i G 2i 1i
i
C G A B HD
s t t 2
] a! 1i !huN # h# 1 z ! 1 q
K K B2 1i B2 1
1i 2 1 1
1
# [K K (s #r~2t~1#K !K )#s2 K
G 1i 2i 2 1 1i 1i 2i
C G HD
1 t 2
#K K (K !K )] b! huN #s z # 1 q
1i 2 2i 2 K 1i 1i B2 1
1i 1
2K
# 2(s K #K K !K K )
G 1i 2i 1i 2 1i 2i
C G A B HD
s t t
] a! 1i !huN # h# 1 z ! 1 q
K K B2 1i B2 1
1i 2 1 1
C G HDHD
1 t
] b! huN #s z # 1 q db da. (A.8)
K 1i 1i B2 1
1i 1
The integration is straightforward but tedious. In order to save space, we simply
report the end result of the calculation. The above integral can be shown to be
proportional to
C G A B A B A BCA B
1 D G D 2 2 D t
!exp ! !2P 1i ! 1i # 1i huN # 1 q
2 1 r H r H r B2 1
i i i 1
]MK (s #r~2t~1#K !K )#(K #s )(K !K )N
2i 2 1 1i 2 1i 2i 2
#s z MK (s #s #r~2t~1)#(K !K #s )(K !K )]
1i 1i 2i 1 2 2 1 1 2i 2
C A B
K D
! 2i ! 1i MK (s #r~2t~1#K !K )
H(H#K K2) r 1i 2 1 1i
1i 2 i
G A B HD HD
t t 2
#s2 #K s N#K s huN ! h# 1 z # 1 q , (A.9)
1i 2 1i 2 1i B2 1i B2 1
1 1
where
H,K K (s #r~2t~1#K !K )#s2 K #K K (K !K ).

1i 2i 2 1 1i 1i 2i 1i 2 2i 2
By partially differentiating the above with respect to D /r and simplifying, we

1i i
get
C A B
K #s #s #r~2t~1 t
D "r s z # 2 1 2 huN # 1 q
1i i 1i 1i K !K #2s #s #r~2t~1 B2 1
2 1 1 2 1
D
K (s #r~2t~1#K !K )#s2 #K K
! 1i 2 1 1i 1i 1i 2P . (A.10)
K !K #2s #s #r~2t~1 1
2 1 1 2
By applying market clearing condition, we get
A B
Avr[D ]#x K #s #s #r~2t~1 t
0" 1i 1"s u# 2 1 2 huN # 1 q
r 1 K !K #2s #s #r~2t~1 B2 1
2 1 1 2 1
x K (K #s #r~2t~1)#s2
# 1! 1 2 2 1 P . (A.11)
r K !K #2s #s #r~2t~1 1
2 1 1 2
This can be rewritten as
C
1
P " (K #s #s #r~2t~1)
1 K (K #s #r~2t~1)#s2 2 1 2
1 2 2 2 1
A B A BD
t x
] huN # 1 q #(K !K #2s #s #r~2t~1) s u# 1 . (A.12)
B2 1 2 1 1 2 1 r
1
Since this expression must be equivalent to Eq. (A.1) in a rational expectations
equilibrium, we have B "1/rs . The above can then be rewritten as
1 1
C
1
P " (K #s #s #r~2t~1)
1 K (K #s #r~2t~1)#s2 2 1 2
1 2 2 2 1
A BD
x
](huN #r2s2t q )#(K !K #2s #s #r~2t~1) s u# 1
11 1 2 1 1 2 1 r
(A.13)
or
1
P " [huN #(s #r2s2t )q ]
1 K 1 11 1
1
hs (K !s )
! 1 1 1 (q !uN ).
K MK (K #s #r~2t~1)#s2N 1
1 1 2 2 2 1
(A.14)
From Eqs. (A.10) and (A.14) we can rewrite D as
1i
D "r [(s z !s q )!(K !K )P ]. (A.15)
1i i 1i 1i 1 1 1i 1 1
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Journal Article Analyzes Pre-Announcement and Event-Period Private Information

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Journal of Accounting and Economics 24 (1997) 395—419

Pre-announcement and event-period private

Received 1 March 1997; received in revised form 1 November 1997

Pre-announcement information is private information gathered in anticipation of

JEL classification: M4; G14

Keywords: Capital markets; Trading volume; Announcements

0165-4101/97/$17.00 ( 1997 Elsevier Science B.V. All rights reserved.

information is not subsumed by the announcement itself, pre-announcement

1 This error is discussed at the end of Section 2 of this paper.

absolute value price change documented throughout the empirical literature

2. The model and market equilibrium

We begin by taking the rational expectations trading model suggested in

4 Their analysis of the fully informed case is in footnote 8 of their paper.

The three sources of information are combined to form an investor’s expecta-

which, in turn, reflect investors’ information. Price at time 2, i.e., P , is

3. Price change and volume

Proposition 1. Per-capita trading volume at the time of the earnings announcement

Proposition 1 shows that the magnitude of trading volume depends on the

Corollary 1. ¼hen there exists no event-period private information

investors. Alternatively, if the information is ‘bad news’ (i.e., P !P (0), it is

consequences of the public announcement at time 2. When there exists no

In this section we attempt to determine proxies for investors’ differential

In this analysis, we incorporate both pre-announcement and event-period

the existence of event-period information. Even in the absence of empirical

Appendix A. Calculation of rational expectations equilibrium

Let the linear conjecture of P and P be written as

huN #s z #(t /B2)q #ny#s z #(t /B2) q

From Eqs. (A.3) and (A.6) we can rewrite D as

Max E[º (¼ )Dz ,P ]

G,(K !K )(s #r~2t~1)!s2#(s !s )(K !K #2s ).

H,K K (s #r~2t~1#K !K )#s2 K #K K (K !K ).

By partially differentiating the above with respect to D /r and simplifying, we

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