The uncertain information hypothesis (UIH), first tested by Brown et al (1988), evolves from the suggestion that markets at times misprice information due to investors risk averseness.
The origin of this school of thought is Fama (1965) where it was discussed that large share price changes are often followed by random irresolute responses. This observation counters the EMH rational and instantaneous response assumption in a case of an important information surprise on the market. To refine EMH, Brown et al (1988) proposed the UIH which too assumes rational investor behaviour. Under UIH, when a sudden substantial piece of information gets to the market, the first reaction does not reflect that full price of the event‟s value. Thereafter, as the market begins to understand the effects of the event, prices adjust accordingly until the true price of the event is established. It may be argued that despite
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investors being rational, there is information asymmetry in the market, possibly arising from the separation of the firm from its owners (entity concept). As a result, semi-strong EMH is unattained leading to traces of over- or under-reaction to information, showing uncertainty in the impact of the disclosures. Dependant on the value of the disclosures, such as complementary and supplementary narratives, and ability of investors to fully and rightly interpret the event, the post-announcement drifts are intended to rectify the price to the true price of the announcement.
Brown, et al (1989) exemplify UIH with a sudden arrival of a piece of unexpected bad news on the market about the firm, say, a sudden demise of an executive. Investors will quickly mark down the value of the firm‟s shares. However, given that the only true assessment of the event can only be possible on announcement of a replacement, investors can only have subjective assessment in the interim about the long-term effect of the event. The result therefore is a double-effect on the firm‟s share value where the first impact is the event itself and the second is the magnitude of the event. Similar reaction, though in opposite direction is expected for good news.
As a cohort to this theorem, DeBondt and Thaler (1985) through their Over Reaction Hypothesis (ORH) concur that markets habitually over react to new information and have to persistently revise their original pricing of the news. However, the two theories differ as far as good news is concerned (Brown et al. 1989). Rather than over reaction, good news leads to an under reaction where the first reaction attributed to the sudden good news is a share price increase and the second reaction based on the magnitude is reacted to by further price increase.
Diagram 3 shows a simulation by Brown, et al (1989) of share price adjustment under EMH, UIH and ORH on receipt of a new piece of information on stock exchange.
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Diagram 3 Stock Price Changes in Response to Bad and Good Uncertain Information
Source : Brown, et al (1989, p. 49)
Panel A shows a price adjustment under EMH when bad news in announced. There reaction is an instant downgrading of prices and accurate such that no further price movement as a result of the news is experienced. Panel B presents a reaction to bad news under UIH and ORH. There is an instant overreaction due to the systematic risk embedded in the uncertain event. Thereafter, as investors understand the full impact of the event, they revise pricing upwards to the true value of the event. Panel C shows the perfect pricing scenario for good news. Panel D shows the reaction to good news under ORH. In this case, the new leads to an overreaction and as investors comprehend the influence of the news, they revise the prices downwards to the true value. Panel E shows the reaction to good news under UIH. In this case, the uncertainty in the good news will compel investors to under react at the announcement time and later revise their prices upwards. In summary, the UIH presupposes that the average (or aggregated reaction to major uncertain events will be an increase in share price returns variability. The instant reaction for bad news is a downward over reaction while for good news it is an upward under reaction. Therefore, for both cases, then revised position in the post-event period is an upward trend in price variability due to reduced uncertainty and risk averseness; as well as the expectation by investors that they will benefit from the news/
event.
Evidence of uncertain information on the capital markets and the subsequent impact on share pricing has been tested in a number of countries for various events. For example, Vuchelen
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(2003) tested the effect of political election results on the Brussels Stock Exchange. Further, Ajayi and Mehdian (1994) used data from stock exchanges in Canada, Germany, France, Italy, Japan, Netherlands, UK and the US to test for evidence of EMH, UIH and ORH by way of post-event volatilities, cumulative abnormal returns and the risk/return relationship. The results confirmed that when the strict certain information assumption by EMH is relaxed, rational investor behaviour was explained by UIH. Also the study showed that the preposition by UIH that markets generally under react to favourable and over react to unfavourable news was more prevalent than the suggestion by ORH that markets over react to new information regardless of whether it is good or bad. Yu, et al (2009) tested for the UIH on the S&P500 and its SPDR using 5 days‟ returns. Before the introduction of the SPDR (1963 – 1993), the return on the S&P500 showed a persistent one-day pattern. This contradicted both UIH and EMH since the result was both predictable and persistent. In the post-SPDR period (1994 – 2003), there was strong evidence for presence of UIH as investors showed an overreaction to bad news as the 5-day post event returns were a result of a series of positive upward price revisions. However, irrespective of the vast evidence of UIH, Brown et al (1989) contend the efficacy of rejecting the EMH and its assumptions in favour of alternative theories that have not fully developed as EMH with regards to explaining finance theory.
Relating to evidence presented on the pattern of reaction to the announcement of interim reports in the UK and the discussion above on UIH, EMH and ORH there are various conclusions. In Rippington and Taffler (1995), the pattern seems to support the argument for good news under ORH as there is sharp increase in average absolute abnormal returns on the event day followed by a sharp decline in the two days after the event. Based on the frequency ranking of abnormal returns for 5 days around the interim report, results in Opong (1995) may be supportive of the ORH as there is a sharp rise on the interim date followed by a gradual decline in abnormal returns on the following days. Likewise, recent evidence in Wolfe et al (2009) where abnormal return dispersions were used for FTSE350 companies, the pattern for good news under ORH was observed.
Commenting on the UK interim report information content studies reviewed above, the peculiar observation is that although good news under ORH is reflected, the studies do not
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refer to interim reports as good news but rather consider the information highly impactful. It may then be concluded that though the studies observe that announcement of UK interim reports is a major event having an immediate upward thrust on share price returns and a downward trend in the post-event days, there may be an indication ORH for good news for event of interim reporting announcement.
Given that all the literature above on information content of UK interim reports have no mention about narrative disclosure attributions in interim report information, in this thesis the shortfall is considered. UIH is justified on attributions of good and bad news. In fact, the suggestion by Brown et al (1989) that UIH is a two-impact phenomena (first – the shock of the news and two – the true value established through reduction of uncertainty), narrative disclosure attributions arguably take a pivotal role on the second degree of impact. As conjectured in disclosure extent literature (e.g. Beattie et al. 2004; Beattie and Thomson 2007;
Hooks et al. 2002a; Wallace and Nasser 1995), attributions may be considered to exhibit quality in disclosures. This quality arguably explains their role in affecting share price returns.
Another observation is that UIH and ORH are only associated to good and bad news attributions. Since the good and bad news attribute is only part of the set of attributions that are found in interim reports narrative commentaries, this study conjectures that the two theories may be applicable to other attributions that possess qualitative properties of information. The application of UIH and ORH to these other attributes is discussed in the hypothesis development in Chapter 7. However, since the researchers on UIH (e.g. Brown et al. 1988) and ORH (e.g. Debondt and Thaler 1985) only subjected their theories to instances of good and bad news, there is need to consider other market for information theories that may apply other disclosure attributions with regard to information content of complementary and supplementary narratives. These theories are discussed below.