Stock Price Crash Risk

The series of corporate scandals (Enron, WorldCom, Satyam) and the recent financial crisis has revived the interest of regulators, practitioners, and researchers to investigate stock price crash risk. Stock price crash risk is defined as the conditional skewness of return distribution and it captures asymmetry in the risk associated with the stock (Kim et. al., 2014). Alternately, it can be understood as the phenomenon which usually occurs due to the presence of bubbles in the stock price (Moradzadehfard, 2011). Stock price crash risk is an important consideration for investment decisions and risk management.

Selfish management practices such as tax evasion, doing the project with negative present value, and lack of transparency of financial information are some of the frequently cited reasons for stock price crashes. In the absence of optimal contracts, selfish managers can exploit their informational advantage and engage in short-sighted, opportunistic behavior at the expense of long-run shareholders. In general, such actions, i.e. undertaking investment decisions that aim to temporarily boost valuations, or engaging in earnings management to preserve an inflated stock price, are unsustainable and will eventually results in stock price crashes when the true fundamentals are revealed.

The research in the field of crash risk argues that a stock price crash occurs when investors realize that stock prices have been inflated. Jin and Myers (2006) reported that the information asymmetry between managers and shareholders, coupled with managers’ self-interest, is related to stock price crash risk. Hutton et al. (2009) reported that opaque earnings are associated with higher stock price crash risk and demonstrated that poor accruals quality in reported earnings allows managers to conceal bad news, which leads to stock price crashes. Similarly, Kim et al. (2011a) investigated how crashes arise from managers’ bad news hoarding, which could be induced by equity-based compensation. Kim et al. (2011b) studied crash risk in the context of corporate tax avoidance. Similarly, Callen and Fang (2011) explored stock price crashes in the context of lack of auditor monitoring.

A considerable body of literature suggests that effective corporate governance mechanisms can curb such sub-optimal managerial decision-making (Shleifer and Vishny (1997), Healy et al. (1999)). This is achieved, for instance, by disciplining investments (Masulis et al., (2007)), preventing earnings management (Xie et al., (2003)), and improving the information environment (Armstrong et al., (2012), Karamanou et. al. (2005)). These findings suggest that since effective corporate governance mechanisms help to reduce opportunistic managerial behavior, they should also be associated with lower firm-specific stock price crashes. Thus, likelihood of stock price crash can be used as an indicator of corporate governance effectiveness. In other words, lower rate of stock price crash indicates higher effectiveness of corporate governance mechanism.

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