Joint with Daniel Taylor, Robert Verrecchia
Revised March 11 2015
We extend the CAPM to a setting where a firm provides a report of its future cash flow with error before its shares are publicly traded. We show that an entrepreneur, as representative of a firm's initial owners, will choose to provide a report that asymmetrically reflects future cash flow. Under very innocuous assumptions, we show that a firm's report will reflect future cash flow to a greater (lesser) extent in bad states (good states) –– when that cash flow is expected to be low (high). In effect, reporting is skewed endogenously toward anticipated unfavorable outcomes. We also show that the asymmetry in reporting generates asymmetry in systematic risk. When a firm's report reflects expected future cash flow to a greater extent in bad states, the firm's covariance with the market portfolio will be lower in bad states.