TAILIEUCHUNG - Firm Size and Cyclical Variations in Stock Returns

As companies quoted on UK stock markets do not generally publish their own earnings guidance, the role analysts play in forecasting a company’s performance is vital in setting market expectations about its likely profitability and future growth. This becomes the central benchmark by which companies are judged. A company must remain very conscious of the market’s expectations of its performance and immediately inform the market if they become aware that they are likely to diverge materially from consensus analyst forecasts - in the form of issuing either a profits warning, or an upgrade statement. Analysts therefore play a pivotal role in the. | Firm Size and Cyclical Variations in Stock Returns Gabriel Perez-Quiros Allan Timmermann July 15 1999 ABSTRACT Recent imperfect capital market theories predict the presence of asymmetries in the variation of small and large hrms risk over the economic cycle. Small hrms with little collateral should be more strongly affected by tighter credit market conditions in a recession state than large better collateralized ones. This paper adopts a flexible econometric model to analyse these implications empirically. Consistent with theory small firms display the highest degree of asymmetry in their risk across recession and expansion states and this translates into a higher sensitivity of these firms expected stock returns with respect to variables that measure credit market conditions. Recent imperfect capital market theories . Bernanke and Gertler 1989 Gertler and Gilchrist 1994 Kiyotaki and Moore 1997 predict that changing credit market conditions can have very different effects on small and large firms risk. Agency costs induced by asymmetry in the information held by firms and their creditors make it necessary for firms to use collateral when borrowing in the credit markets. Small firms it is argued typically do not have nearly as much collateral as large firms and will not have the same ability to raise external funds. Therefore small firms will be more adversely affected by lower liquidity and higher short-term interest rates. Such theories do not simply have the cross-sectional implication that small firms risk will be more strongly affected by tighter credit markets in all economic states. Based on the idea that a decline in a borrower s net worth raises the agency cost on external finance the theories identify asymmetries in the effect of tighter credit market conditions on risk during recessions and expansions. In a recession small firms net worth and hence their collateral will be lower than usual and tighter credit markets will be associated with stronger .

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