Introduction

The earnings response coefficient, or ERC, is the estimated relationship between equity returns

Return on equity

Return on equity measures the rate of return on the ownership interest of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity . ROE shows how well a company uses investment funds to generate earnings growth...

 and the unexpected portion of (i.e., new information in) companies' earnings announcements.

In financial economics

Financial economics

Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....

, arbitrage pricing theory

Arbitrage pricing theory

In finance, arbitrage pricing theory is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a...

 describes the theoretical relationship between information that is known to market participants about a particular equity (e.g., a common stock share of a particular company) and the price of that equity. Under the efficient market hypothesis

Efficient market hypothesis

In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...

, equity prices are expected in the aggregate to reflect all relevant information at a given time. Market participants with superior information are expected to exploit that information until share prices have effectively impounded the information. Therefore, in the aggregate, a portion of changes in a company's share price is expected to result from changes in the relevant information available to the market. The ERC is an estimate of the change in a company's stock price due to the information provided in a company's earnings announcement.

The ERC is expressed mathematically as follows:

R = the unexpected return

a = benchmark rate

b = earning response coefficient = (actual earnings less expected earnings) = unexpected earnings

e = random movement

Use & Debate

ERCs are used primarily in research in accounting and finance

Finance

"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

. In particular, ERCs have been used in research in positive accounting

Positive accounting

Positive accounting is the branch of academic research in accounting that seeks to explain and predict actual accounting practices. This contrasts with normative accounting, that seeks to derive and prescribe "optimal" accounting standards.- Background :...

, a branch of financial accounting research, as they theoretically describe how markets react to different information events. Research in Finance has used ERCs to study, among other things, how different investors react to information events. (Hotchkiss & Strickland 2003)

There is some debate concerning the true nature and strength of the ERC relationship. As demonstrated in the above model, the ERC is generally considered to be the slope coefficient of a linear equation

Linear equation

A linear equation is an algebraic equation in which each term is either a constant or the product of a constant and a single variable....

 between unexpected earnings and equity return. However, certain research results suggest that the relationship is nonlinear

Nonlinear regression

In statistics, nonlinear regression is a form of regression analysis in which observational data are modeled by a function which is a nonlinear combination of the model parameters and depends on one or more independent variables...

.(Freeman & Tse 1992)