Capital Market Trust in Management - An empirical study on trust in management with regard to investors’ risk perception and capital market effects

Abstract

Background & Problem Definition: One of the primary functions of financial accounting is to establish trust and to provide reliable, credible and useful information to its users, such as investors, in order for the capital markets to function. Managers have an important role in providing financial statements with high credibility as well as in the creation and maintenance of trust in accounting. If trust can be assumed to be an alternative to increased information and a factor that reduces uncertainty, it can be argued that trust in management would result in a lower perceived risk among investors and a lower cost of equity capital from the firm’s perspective. Purpose: The purpose of this study is to test whether trust in management is associated with a lower perceived risk among investors and, thus, can have any real economic consequences for the capital market. Research Design & Methodology: The hypothesis is tested on a sample of European companies with listed stocks. Trust in management is defined as tenure on the job for top management, while the bid-ask spread, share price volatility, trading volume and analyst forecast dispersion serve as proxies for investors’ perceived risk or uncertainty and consequently as indicators of the effect on a firm’s cost of capital. Results & Conclusion: The empirical results indicate that trust could have both a direct and an indirect effect on investors’ risk perception, which suggests that trust can have real economic consequences for the capital market. When the bid-ask spread is used as a proxy, the study provides evidence of a statistically significant negative association between trust in management and investors’ perceived risk or uncertainty. This suggests that trust in management could lower the perceived risk of investors and consequently a firm’s cost of capital. However, the other proxies for risk show an association with trust that has the opposite direction from what was first anticipated, which suggests that the association is more complex than first expected. Thus, further research is needed before any general conclusions can be made.