Is business strategy a priced fundamental-broad information risk factor?

While Francis et al. (2005) claim that accruals quality as a proxy for information risk is priced by investors, Core et al. (2008) find no pricing evidence for accruals quality and suggest future studies use a broader or more fundamental proxy for information risk to investigate the pricing of information risk. Subsequently, Ogneva (2012) suggests that the lack of pricing evidence on accruals quality as documented by Core et al. (2008) is due to the offsetting effect of such risk, for instance through cash flow shocks, on asset prices. Thus, whether information risk is priced by investors remains an empirical question. The purpose of this thesis is to investigate the pricing of information risk. The investigation is conducted as follows. First, the thesis identifies a proxy for information risk comprising various components that are likely to be priced differently by investors. Second, it shows that the lack of pricing evidence on such proxy (similar to accruals quality) could be due to the offsetting effect of the risk of such components on asset prices. As suggested by Core et al. (2008), the effect of a fundamental or broad information risk proxy is more likely to be captured in asset prices when testing the pricing of information risk. Following that suggestion, this thesis employs an ex ante and fundamental-broad information risk proxy, that is business strategy, to investigate the pricing of information risk. This thesis identifies a firm's business strategy through the methodology of Bentley et al. (2013), which is based on the Miles and Snow (1978) strategic typology, and focuses on the contrasting innovation-oriented prospector versus efficiency-oriented defender strategies. Bentley et al. (2013) suggest that prospectors experience higher inherent information asymmetry (i.e. poorer quality of information), whereas Bentley et al. (2014) argue that defenders exhibit a poorer external information environment (i.e. less quantity of information). According to Easley and O'Hara (2004), both quality and quantity of information are relevant to equity pricing. Thus, it is possible that investors simultaneously associate the innovation component of business strategy which signifies higher inherent information asymmetry (i.e. poorer quality of information) with a higher required rate of return, and the efficiency component of business strategy which signifies poorer external information environment (i.e. less quantity of information) with a higher required rate of return. The pricings of these two components may offset each other yielding insignificant pricing of business strategy. With U.S. data spanning 1972-2010, the thesis conducts a battery of asset pricing tests and concludes that business strategy, in aggregate, is not priced by investors. Therefore, the results do not lend support to Core et al.'s (2008) suggestion that a fundamental-broad information risk proxy can maximize the likelihood of information risk being captured in the asset pricing models, as it neglects the potential offsetting effect of the information risk proxy on asset prices as noted by Ogneva (2012). Further analyses provide evidence supporting the offsetting pricing effect argument of business strategy components, rather than the traditional view that information risk is diversifiable and thus irrelevant to equity pricing (Fama, 1991). Specifically, investors, simultaneously price innovation and efficiency components of business strategy, leading to insignificant business strategy pricing in aggregate.