We examine the role of earnings management in explaining the
properties of asset prices and stock market participation. We
demonstrate that investors' uncertainty about the extent of
manipulation can cause excess movements in stock price relative to
fluctuations in output. When faced with information asymmetry about
fundamentals in the presence of earnings management, investors
demand a higher equity premium for bearing the additional risk
associated with their payoffs. In addition, when investors have
heterogeneous beliefs about managerial manipulation, the dispersion
in belief endogenously gives rise to limited stock market
participation. Our model suggests that the increasing stringency of
corporate governance and varying composition of investors may have
played a role in the contemporaneous run-up of market participation
rates in the recent years.
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