‘Trading Volume and Price Reactions to Public Announcements Oliver Kim; Robert E. Verrecchia Journal of Accounting Research, Vol. 29, No. 2 (Autumn, 1991), 302-321, Stable URL: ttt flinksjstor.orgsicisici=00021-8456% 28199 123%2020%3A2%9C90223 ATV APR MSE. 0.CO%IB2P Journal of Accounting Research is currently published by The Instcute of Professional Accounting, Graduate Schoo! of Business, University of Chicago. Your use of the ISTOR archive indicates your acceptance of [STOR's Terms and Conditions of Use, available at tlp//ewvejstororglabouttenms.html. ISTOR's Terms and Conditions of Use provides, in pat, chat unless you fave obtained pcior permission, you may not dowaload an cnt isus of @ journal or multiple copies of articles, and you may use content inthe ISTOR archive only for your personal, non-commercial uss. Please contact the publisher cegarding any further use of this work. 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Introduction “The purpose of this study is to investigate. theoretically how the price and volume reactions to a publie announcement are related to each ather, t the announcement’s characteristies, and to the traders’ beliefs at the time of the announcement, Among many possible sources of (abnormal) ‘trading volume at the time of a public announcement, our emphasis in this study is on differences in the quality of preannouncement informa- tion. The study uses a two-period rational expectations model. Traders achieve their optimal portfolios prior to the announcement by trading on ‘what each knows in the preannouncement period. The public announce- ment changes tradets’ beliefs and induces them to engage in a new round of trade, It is assumed that traders are diversely informed and differ in the precision of their private prior information; they therefore respond differently to the announcement, and this leads to positive volume, We obiain three results. First, the price change at the time of an nouncement: is proportional to both the unexpected portion of the an- nouncement and its relative importance across the posterior beliefs of traders. This relative importance is increasing in the precision of the announcement and decreasing in the precision of the preannouncement information. * University of California, Loe Angeles; *Universty of Ponnevivania. We gracefully ‘scknowledge the coments of Bob Holthansen, Prom Jain, Rich Larcher, Bhazar Sarath, ‘Scott Sticke, and dhe workshop participants Berkeley, Columbia, Univetsity of Michigan, University of Minnesota, MAT, Northwestern, University of Pittsburgh, University of achester, UCLA, Washington, ane Vale. We alto thank an anonymous refecos fer any Inepfuleuggestions 2 Copyright©, Journal of Accounting Reser, 193,TRADING VOLUME AND PRICE REACTIONS — 203 ‘Phe second and main result is that trading volume is proportional to both the absolute price change and a measure of differential precision across traders. Price change, as Beaver [1968] paints out, reflects the average change in traders’ beliefs due to the announcement, whereas trading volume reflects traders’ idiosyncratic reactions, In this study the different reactions of traders are caused by differing precisions of their private information, The newly announced information is relatively more important to traders with less precise private information and thus has 4 larger impact on theit beliefs. Volume reflects the sum of differences in traders’ reactions; the change in price measures only the average reaction. As a result, volume is proportional both to price change and to the degree of differential precision. If precision is unobservable, the first and the second results together suggest that trading volume may be a noisier indicator of the precision of the announcement, or the precision of the preannouncement information, than price change. Also, this result is consistent with the empirical findings that abnormal volume is posi- tively correlated with absolute abnormal returns ‘The third result is a generalization of Holthausen and Verrecchia [1988], who analyze price changes at public announcements in a two- period model. In their model investors do not possess private information and thus have homogeneous beliefs. They show that the price reaction to an announcement is, on average, increasing in its precision and decreasing in the amount of preannouncement information.’ We show that the expected volume and the variance of price change are incteasing functions of the precision of the announced information and decreasing functions of the amount of preannouncement public and private infor mation. Therefore, the intuition and results of Holthausen and Verrec- chia [1988] concerning price reaction extend to volume even when investors are informed diversely and with different precisions. In related research, Pfleiderer [1984] and Holthausen and Verrecchia [1990] consider volume that arises due to differences in interpreting the announcement across traders” Grundy and McNichols [1989] analyze volume arising from the correction of idiosyneratic etrors induced by the revelation of information through prices? Varian [1985] considers volume due to differences in prior beliets.* Our model should not be interpreted too broadly, although it provides » Sings teaders have hamagenenus beliefs, na trade occurs * See Indejikin (2991] for an extension ofthis dea. * Other rational expectations morals chat employ 2 two-peviod trading structure include Brown and Jennings (1987) snd Krishnan (1987). “We mentioned only those studios using Groseman type rational expectations model Studies which assume different matket strictures inehige Kye [1985], Claten and Milgrom (1985), Kaxpoft (1986), and Admati and Pfleiderer (1988). Alo, eee Tauchen and Pitts [1985 and Harpott [1987] forthe relation between volume and price change zot explicitly related to the arrival of now information and its properties, and Verrecchia [1981] far 4 discussion of what inferenoss can be drawn ftom volume.