Differences in Prior Beliefs, Differential Interpretation, and the Consensus Effect of Quarterly Earnings Signals and Trading Volume

Abstract

Models of financial economists including Karpoff, Varian, Holthausen and Verrecchia, and Dontoh and Ronen have demonstrated that there are three distinct fundamental determinants of trading volume reaction to new information releases: first, the extent of differences in investors’ prior beliefs; second, differences in their interpretations of the information; and third, the level of consensus that the information release induces among them. Although these effects are well understood theoretically, empirical studies that investigate trading volume reaction to the arrival of new information have tended to combine these three fundamental determinants, thereby masking their distinct incremental effects on trade. In this article, we examine all three potential sources of trade in response to information: heterogeneous prior beliefs, differential interpretation, and the consensus effect of the news. We find that all three of these effects have a distinct incremental impact on trading volume, thereby corroborating the theoretical models of financial economists.