We propose that executive overconfidence, defined as having unrealistic (positive) beliefs about future performance, increases a firm's propensity to commit financial reporting fraud. Moderately overconfident executives are more likely to "borrow" from the future to manage earnings thinking it will be sufficient to cover reversals. On average, however, they are wrong, and the managers are compelled to engage in greater earnings management or come clean. Using industry, firm, and executive level proxies for overconfidence, we provide evidence consistent with this hypothesis. Additional analysis suggests a distinction between moderately and extremely overconfident executives. The extremely overconfident executives are simply opportunistic. We find no evidence that non-fraud firms have stronger governance to mitigate fraud.

Strategic disclosure, defined as reporting good news and withholding bad news, predicts a negative relation between returns and residual uncertainty, and thus predicts asymmetric return volatility. Using litigation risk incentives to identify cross-sectional and time-series variation in strategic disclosure propensity, we document a positive relation between strategic disclosure and asymmetric return volatility. At the market level, asymmetric return volatility is stronger for U.S. firms after the Private Securities Litigation Reform Act (PSLRA) and for Canadian firms relative to U.S. firms. At the firm level, asymmetric volatility is weaker for firms in industries with high risk of shareholder litigation and after a shareholder suit is filed.

This paper examines the link between disclosure and the cost of capital. We exploit an exogenous cost of capital shock created by the Enron scandal in Fall 2001 and analyze firms' disclosure responses to this shock. These tests are opposite to the typical research design that analyzes cost of capital responses to disclosure changes. In reversing the tests and using an exogenous shock, we mitigate concerns about omitted variables in traditional cross-sectional disclosure studies. We estimate shocks to firms' betas around the Enron events and the ensuing transparency crisis. Our analysis shows that these beta shocks are associated with increased disclosure. Firms expand the number of pages of their annual 10-K filings, notably the sections containing the financial statements and footnotes. The increase in disclosure is particularly pronounced for firms that have positive cost of capital shocks and larger financing needs. We also find that firms respond with additional interim disclosures (e.g., 8-K filings) and that these disclosures are complementary to the 10-K disclosures. Finally, we show that firms' disclosure responses reduce firms' costs of capital and hence the impact of the transparency crisis.

Stocks of firms that maintain exposure to the assets underlying their operations offer a substitute for direct investment in assets that are otherwise unavailable or costly to acquire. For stocks in the 30 Fama-French industries during the period from 1983 to 2006, we show that investor interest in stocks varies with their industry exposure, where investor interest is measured by share turnover and the number of institutions and mutual funds that hold the firm's stock. The association is unrelated to levels of diversification. Attraction to industry exposure is greatest in industries in which returns differ significantly from those of the aggregate market portfolio, wherein the benefits from investing in industry exposed stocks as substitutes for the underlying assets are greatest. Preferences for industry exposure are least pronounced for banks, which face high fiduciary standards, and most pronounced for transient investors investing based on public information and for sector funds seeking industry exposure.