The Effect of Trading Volume on Analysts’ Forecast Bias

Abstract

ABSTRACT: This study models the interaction between a sell-side analyst and risk-averse investors. It derives an analyst’s optimal earnings forecast and investors’ optimal trading decisions in a setting where the analyst’s payoff depends on the trading volume the forecast generates as well as on the forecast error. In the fully separating equilibrium, we find that the analyst biases the forecast upward (downward) if his private signal reveals relatively good (bad) news. The model predicts that: (1) the analyst biases the forecast upward more often than downward and the forecast is on average optimistic; (2) the magnitude of the analyst’s bias is increasing in the per-share benefit from trading volume he receives; and (3) the analyst’s expected squared forecast error may increase in the precision of his private information. Finally, we characterize the circumstances under which the (rational) analyst acts as if he overweights or underweights his private information.