News-Driven Return Reversals: Liquidity Provision Ahead of Earnings News – Eric C. So, Massachusetts Institute of Technology (MIT) – Sloan School of Management; Sean Wang, University of North Carolina Kenan-Flagler Business School. June 7, 2013

“This study documents a six-fold increase in short-term return reversals during earnings announcements relative to non-announcement periods. Following prior research, we use reversals as a proxy for expected returns market makers demand for providing liquidity. Our findings suggest that market makers demand higher expected returns prior to earnings announcements because of increased inventory risks that stem from holding net positions through the release of anticipated earnings news. These findings indicate that increases in market makers’ inventory risks result in reduced liquidity through a channel distinct from adverse selection risks and that pre-announcement demand for liquidity provision results in predictable variation in earnings announcement returns. We also use pre-announcement option prices to show that return reversals increase when there is greater expected volatility during earnings announcements. Collectively, our findings suggest that uncertainty regarding anticipated information events elicits predictable increases in expected returns to liquidity provision and that these increases significantly affect the dynamics and information content of market prices.“