Effects of Disclosure Quality on Market Mispricing: Evidence from Derivative-Related Loss Announcements

Although previous research has suggested that the level of disclosure is positively related to stock market efficiency, it remains unclear whether an increase in the level of disclosure can facilitate price discovery regardless of the quality of information provided in the disclosure. We examine stock returns around 131 derivative-related loss announcements in the Korean stock market from March 2008 to June 2009 to study how disclosure quality might affect the manner in which newly disclosed information is incorporated into stock prices. To properly price derivative-related losses, investors need to differentiate 'over-hedged' firms from 'non-over-hedged' firms, because only those losses in excess of offsetting gains from underlying assets denominated in a foreign currency adversely affect overall profitability. We find that investors are likely to misprice derivative-related losses in non-over-hedged firms when information on the underlying foreign currency position is unavailable around the announcement of such losses. This implies that mechanically increasing the quantity of disclosures does not necessarily facilitate a more rational equity valuation, and thus suggests that policymakers should also consider the quality of information being provided when attempting to improve capital market efficiency by mandating more disclosures.