Re-Examining the Association Between Unexpected Earnings and Abnormal Security Returns in the Present of Financial Leverage

Abstract

This study re-examines the theoretical prediction of Dhaliwal et al. (1991) about the association between leverage and earnings response coefficients (ERCs). Since leverage and default risk are endogenous, the estimation using leverage to proxy for default risk may produce biased results. We use a propensity score matching method to deal with this endogeneity and introduce dividend payouts as another proxy for default risk. We find that higher default risk firms are consistently associated with lower ERCs. Our findings suggest that a combination of dividend payouts and leverage is a more refined proxy for default risk.