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Informed Trading and Price Discovery Before Corporate Events

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Informed Trading and Price Discovery Before Corporate Events ARTICLE IN PRESS JID: FINEC [m3Gdc; June 28, 2017;21:7 ] Journal of Financial Economics 0 0 0 (2017) 1–28 Contents lists available at ScienceDirect Journal of Financial Economics journal homepage: www.elsevier.com/locate/jfec Informed trading and price discovery before corporate ✩ events ∗ Shmuel Baruch a, Marios Panayides b, Kumar Venkataraman c, a David Eccles School of Business, University of Utah, Salt Lake City, UT 84112, USA b Katz Graduate School of Business, University of Pittsburgh, Pittsburgh, PA 15260, USA c Edwin L. Cox School of Business, Southern Methodist University, Dallas, TX 75275, USA a r t i c l e i n f o a b s t r a c t Article history: Stock prices incorporate less news before negative events than positive events. Further, Received 5 March 2015 informed agents use less price aggressive (limit) orders before negative events and more Revised 8 June 2016 price aggressive (market) orders before positive events (buy–sell asymmetry). Motivated Accepted 29 June 2016 by these patterns, we model the execution risk that informed agents impose on each other Available online xxx and relate the asymmetry to costly short selling. When investor base is narrow, security JEL classifications: borrowing is difficult, or the magnitude of the event is small, buy–sell asymmetry is pro- G11 nounced and price discovery before negative events is lower. Overall, we show that the G12 strategies of informed traders influence the process of price formation in financial mar- G14 kets, as predicted by theory. G18 ©2017 Elsevier B.V. All rights reserved. Keywords: Informed trader Insider trading Limit order Short selling Buy–sell asymmetry 1. Introduction ✩ We thank the editor (Bill Schwert) and, in particular, Gideon Saar (the Informed traders play a central role in price formation referee) for many constructive suggestions. For their comments, we thank in financial markets. In microstructure models (see Kyle, Amber Anand, Leonce Bargeron, Kerry Back, Indraneel Chakraborty, Jeff Coles, Kevin Crotty, Dave Denis, Diane Denis, Amy Edwards, Robert En- 1985; Glosten and Milgrom, 1985), informed traders re- gle, Tom George, Hans Heidle, Stacey Jacobsen, Pankaj Jain, Ron Kaniel, ceive a private signal about the security’s value and build Praveen Kumar, Sebastian Michenaud, Bruce Lehman, Ken Lehn, Swami positions before information is widely available. The mar- Kalpathy, Bige Kahraman, Albert Menkveld, Ling Peng, Gideon Saar, Bob ket participants observe the imbalance created by the in- Schwartz, Wing Wah Tham, Erik Thiessen, Shawn Thomas, Rex Thomp- formed order flow and move prices in the direction of the son, Laura Tuttle, Mathijs Van Dijk, Vish Viswanathan, Sunil Wahal, Ingrid Werner, Chad Zutter, and seminar participants at Arizona State Univer- signal. Thus, the theoretical literature predicts that the ac- sity, Baruch College of the City University of New York, Lehigh Univer- tivities of informed traders influence the informational ef- sity, Rice University, Southern Methodist University, University of Cincin- ficiency of prices before news releases. nati, University of Houston, University of Pittsburgh, University of Toronto, Wilfrid Laurier University, the 2013 Erasmus Liquidity Conference, the 2013 Stern Microstructure Conference, the 2013 Northern Finance Associ- ation Conference, the 2013 European Finance Association Conference, the to Hank Bessembinder for helpful discussions during the development of spring 2015 Conference of the Multinational Finance Society, and US Se- the project. ∗ curities and Exchange Commission. We thank Laurent Fournier and Carole Corresponding author. Huguet of Euronext-Paris for providing data. We are grateful in particular E-mail address: kumar@mail.cox.smu.edu (K. Venkataraman). http://dx.doi.org/10.1016/j.jfineco.2017.05.008 0304-405X/© 2017 Elsevier B.V. All rights reserved. Please cite this article as: S. Baruch et al., Informed trading and price discovery before corporate events, Journal of Financial Economics (2017), http://dx.doi.org/10.1016/j.jfineco.2017.05.008 ARTICLE IN PRESS JID: FINEC [m3Gdc; June 28, 2017;21:7 ] 2 S. Baruch et al. / Journal of Financial Economics 0 0 0 (2017) 1–28 In this study, we present an extension of the theory de- purchases, dividend initiations, and dividend terminations scribing informed trader’s strategies and provide relevant for Euronext-Paris stocks. We attribute the change in trad- empirical evidence on the most basic questions about in- ing activity observed before an unscheduled announce- formed trading: First, how do informed traders build posi- ment relative to a control period for the same firm to the tions, and what explains their strategies? Second, how do actions of informed agents. Using the control period to es- their decisions to use aggressive or passive strategies affect timate the shift in order flow before the event reduces the process through which private information is incorpo- the likelihood that the event effect is explained by time- rated into security prices? Third, how do their strategies invariant firm attributes that influence order submission affect the speed of learning before news releases? Under- on non-event days. standing the behavior of informed agents is central both to We present a model of the informed agent’s choice of validating the well-developed theoretical literature that re- market versus limit orders. The intuition for the model is lates trading strategies to price discovery and to designing as follows. Informed agents face a trade-off between trans- better surveillance systems that monitor and detect insider acting with certainty at a current bid or offer price by plac- trading activity. 1 ing a market order versus managing execution risk in an Despite the importance of understanding how informed attempt to get a better price by placing a limit order. In ad- agents build positions, data limitations have left unan- dition to paying the bid-ask spread, market orders tip off swered many important questions about their strategies. market participants about the private signal and increase In the days leading to corporate announcements, such price impact cost. When other informed agents receive the as those related to mergers and acquisitions (M&As) and same signal and trade on the same side of the market, the earnings releases, prior research presents widespread ev- execution risk of a limit order strategy is particularly high. idence of insider trading activity and stock price move- Our model predicts that informed agents use limit orders ments. 2 Many publicly available data sources, such as when sufficient uncertainty exists about the presence of the NYSE Trade and Quote (TAQ) database, report all the other informed agents and use market orders if they are transactions in a market but do not identify the specific certain that other informed agents are present. These pre- trades of informed agents. Some data on transactions are dictions follow the Kaniel and Liu (2006) theoretical work available from regulatory Form 4 filed by corporate in- showing that informed agents could use limit orders if the siders with the US Securities and Exchange Commission mass of informed agents is sufficiently low. (SEC) (see Seyhun, 1986 ), or from the SEC’s case files Informed agents face less competition when the nature of defendants formally charged with insider trading (see of private information conveys a decrease in stock price. Meulbroek, 1992 ). However, these data sets do not con- Corporate insiders face more constraints when they trade tain order-level information that is necessary to describe on bad news than on good news (see Marin and Olivier, the strategies of informed agents. 2008 ). 4 Informed sellers who do not own the stock incur We examine a data set provided by the Euronext-Paris the cost of borrowing shares. When borrowing costs are exchange with information on all orders submitted for all high, these informed sellers are less likely to trade. Consis- stocks. The Euronext data do not directly identify the or- tent with our model, we report a novel empirical regular- ders of informed agents. To identify informed order flow, ity of an asymmetry in informed agents’ order submission we employ a research design based on the methodology strategies before positive and negative events. We find an from Chae (2005), Graham, Koski, and Loewenstein (2006) , increase in price aggressiveness of buy orders before pos- and Sarkar and Schwartz (2009) . Prior studies show that itive events and a decrease in price aggressiveness of sell uninformed traders decrease participation in periods lead- orders before negative events (henceforth, buy–sell asym- ing to news releases with timing that is known in advance, metry). As in Diamond and Verrecchia (1987) , our model such as earnings announcements. In contrast, uninformed relies on short sale constraints to explain the buy–sell traders cannot anticipate unscheduled news events with asymmetry observed in the data. However, in our model, timing that is a complete surprise, but informed traders the asymmetry emerges not only because some informed can, if their information concerns the event. 3 We exam- sellers decide to abstain, but also because informed sellers ine a sample of unscheduled corporate announcements re- become liquidity providers. lated to M&As, seasoned equity offerings (SEOs), stock re- Our model yields cross-sectional predictions in buy–sell asymmetry based on the anticipated competition among informed sellers. Informed sellers can be one of two types; 1 In this study, the term “informed trader”
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