Corporate Governance. In a fully informed stock market, news regarding the enforcement of federal laws against publicly traded firms would have no effect on target firm stock prices. A "rational expectations hypothesis" predicts that investors would be unaffected by announcements concerning the enforcement actions of federal agencies because current stock prices accurately reflect discounted future cash flows based upon all relevant information. An absence of announcement effects tied to federal law enforcement actions would suggest that the market is fully aware of illegal activity, the probability of getting caught, and the potential sanctions tied to detection and conviction. Future cash flows lost following federal law enforcement actions can include the costs of sacrificing illegal advantages over competitors, investigation expenditures, litigation expenses, and lost reputational capital. An absence of abnormal returns tied to federal law enforcement actions does not mean that there is no cost to being caught; it simply implies that the market correctly anticipates the magnitude and probability of such costs. Here it is important to recognize that the term "caught" does not necessarily imply guilt as well. Under the rational expectations hypothesis, market participants also know the probability of innocent firms being investigated or sued.
A. How would you interpret positive stock-price effects tied to public announcements regarding the enforcement actions of federal agencies?
B. Conversely, how would you interpret negative stock-price effects tied to public announcements regarding the enforcement actions of federal agencies?

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The Answer of Corporate Governance. In a fully informed stock market, news regarding the enforcement of federal laws against publicly traded firms would have no effect on target firm stock prices. A "rational expectations hypothesis" predicts that investors would be unaffected by announcements concerning the enforcement actions of federal agencies because current stock prices accurately reflect discounted future cash flows based upon all relevant information. An absence of announcement effects tied to federal law enforcement actions would suggest that the market is fully aware of illegal activity, the probability of getting caught, and the potential sanctions tied to detection and conviction. Future cash flows lost following federal law enforcement actions can include the costs of sacrificing illegal advantages over competitors, investigation expenditures, litigation expenses, and lost reputational capital. An absence of abnormal returns tied to federal law enforcement actions does not mean that there is no cost to being caught; it simply implies that the market correctly anticipates the magnitude and probability of such costs. Here it is important to recognize that the term "caught" does not necessarily imply guilt as well. Under the rational expectations hypothesis, market participants also know the probability of innocent firms being investigated or sued.
A. How would you interpret positive stock-price effects tied to public announcements regarding the enforcement actions of federal agencies?
B. Conversely, how would you interpret negative stock-price effects tied to public announcements regarding the enforcement actions of federal agencies?