Abstract
Risk disclosures, including quantitative disclosures about variances, have increased as a result of recent regulations. However mandating such disclosure may require additional investments to obtain the required information about variances. Our research first characterizes the equilibrium strategies for voluntary risk disclosures with asymmetric information and then analyzes the impact of mandatory risk disclosures when this requires additional investment in information technology.
We initially consider a capital market with a safe bond and a single risky firm, where the risk-averse investors are uncertain about the variance of future cash flows and about whether the manager possesses private information about this variance. If the manager knows this variance, he may truthfully disclose the variance prior to selling the firm to the investors. We establish the existence of an equilibrium characterized by a disclosure threshold in which the managers, if informed, voluntarily discloses variances below a threshold (favorable news) but not variances above the threshold (unfavorable news). The market-clearing stock prices correctly incorporate the investors? beliefs that, for some exogenous reason, the manager may be uninformed and hence cannot disclose. We show that an increase in the investors? assessed likelihood of the manager being uninformed leads to a higher disclosure threshold and we provide conditions under which an increase in the expected variance causes a higher disclosure threshold.
We extend these results to a capital market with multiple firms whose future cash flows are affected by a common market-wide risk factor with known variance and an idiosyncratic risk factor with unknown variance. We assume each manager can disclose the variance of his firm's idiosyncratic risk. We find that the betas depend on the market-wide disclosures, even though the disclosure strategy of each manager may not.
Finally, we consider the setting where managers can acquire risk information through a costly investment in information technology. We show that in this case, cutoff levels of both the variance and the cost characterize the partial disclosure equilibrium, so that disclosure occurs if the variances and costs are both sufficiently low, but not otherwise. We also show that mandating disclosure may not increase the level of disclosure even for positive investment costs.