Informativeness of Legal Insider Trades

Transcription

1 Informativeness of Legal Insider Trades Bachelor Thesis Student: Johan Cuppen (ANR: ) Supervisor: Peter Cziraki Program: (Pre-) Master Finance

2 TABLE OF CONTENTS I. INTRODUCTION... 3 II. THEORATICAL FRAMEWORK... 5 A. STOCK PRICE BEHAVIOR... 5 B. PRIVATE INFORMATION... 7 C. REGULATION ON INSIDER TRADING... 9 D. THE BID-ASK SPREAD i. INFORMATION ASYMMETRY ii. CORPORATE POLICIES E. VOLUNTARY DISCLOSURE i. PATENT-ANNOUCEMENTS ii. 10B5-1 PLANS F. MARKET EFFECTS III. SUMMARY AND CONCLUSIONS IV. LIST OF REFERENCES

3 I. INTRODUCTION Many prior studies investigated the informational content of insider trading; trading by insiders with potential access to, material, non-public information about a firm. The reason for all this attention going to insiders activities is best summarized in an article in Individual Investor (Feb. 1998, p. 54): Company executives and directors know their business more intimately than any Wall Street analyst ever would. They know when a new product is flying out the door, when inventories are piling up, whether profit margins are expanding or whether production costs are rising (Lakonishok & Lee, 2001, p. 79). This reason provides an answer to why insider trading activities seem to be a very valuable piece of information to outsiders. The most important information regarding insider trading activities is even made public by a newspaper like Wall Street Journal and an online system like Bloomberg. This paper investigates what kind of information investors/analysts can and should take from an insider trade; the paper opens a discussion about the main aspects regarding this informativeness of insider trading. First of all, I look at the relationship between insider trading and stock price behavior. This mainly is about the question if there really exists a relation and what this relation implies. If there appears to be a relation, investors/analysts should use past insider trading to predict future stock price movements. To further investigate this I take a look at the possession of private information by insiders; do they possess information which outsiders do not have and are they trading upon this information. Several years ago countries started to enforce laws due to illegal insider trading; today it is forbidden to trade upon material, non-public information about a firm. Regulation on insider trading was initially enforced in order to reduce the wealth effects insiders take from their transactions; I examine whether this is the case or insiders are still earning abnormal returns on their trading within their companies stocks. Furthermore, I discuss research about the impact this regulation had on the stock price informativeness and what happened to analysts following the firm after insider trading laws were enacted. 3

4 This paper also investigates the relation between an insider who trades and the effect of this trade on the bid-ask spread set by market makers. What do market makers learn from insider trading and which characteristics of this insider trading are valuable to the bid-ask spread. In addition to these characteristics, I look at information asymmetries and corporate policies in relation to the bid-ask spread. After the bid-ask spread I examine whether insiders use their voluntary disclosure opportunities to manipulate the market. To further elaborate on this, I look at two specific voluntary disclosure strategies; disclosure around cases of patent and the so called Rule 10b5-1 -plans. In the end I talk about option and credit markets; within this aspect of insider trading, the effects of option and credit trading on the original underlying stock market are discussed. Finally, there is a chapter which summarizes the main findings present within this paper. I provide a clear picture of what I find on the different aspects of insider trading, as described above. At last I try to draw some conclusions about these aspects when taking these different findings into account. 4

5 II. THEORATICAL FRAMEWORK A. STOCK PRICE BEHAVIOR Prior studies have tried to investigate if the reason for all the attention to insider trading activities, as stated above, can be empirically confirmed. By looking at these different studies it seems that there certainly is a relation between insider trading and short-term stock price behavior. For example, Lakonishok et al. (2001) and Carpenter and Remmers (2001) find that the trading behavior of an insider can be related to the maturation of the market. They state that when insiders are buying markets will move to a more favorable state as before and on average will go down when insiders are selling. This statement is confirmed by Du and Wei (2004) whose results indicate that the rise of insider trading volume will contribute to an increase in the market volatility of a firm s stock. More evidence of a significant relation between insider trading and stock price behavior is taken from past research by Seyhun (1986, 1988, 1992). He provides sufficient evidence that trades made by insiders in the past, strongly relate to the future excess returns realized on this stock. With regard to this, he stated the following: If insiders purchase stock prior to an announcement of favorable information, then insiders purchases will be followed by positive abnormal returns. If insiders also refrain from purchasing stock until after unfavorable information is announced, then insiders purchases will be preceded by negative abnormal returns (Seyhun, 1986, p. 196). His results also show that 60-percent of future excess stock returns are related to aggregate trading by insiders. The above indicates that insider trading is a very important piece of information to investors. Without acquiring data with regard to insider trading, they are not able to get a complete picture of how a stock is going to perform in the future. The latter statement is confirmed by the fact that insider trading is related to a part of stock price movements which is not related to future real activity, dividend yields, past stock returns, and term of default spreads (Seyhun, 1992). But the Ivan Boesky-case, investigated by Chakravarty and McConnell (1999), presents a different result on this subject. They find that there certainly exists a relation between Ivan Boesky s insider trading and the price changes of the Carnation stock, just prior to Nestlé s acquisition in the summer of But despite 5

6 this evidence they are unable to distinguish the effect of Ivan Boesky s-buys from buys by other market participants on the Carnation stock. I make a few remarks with regard to the informational content of insider trading. First, there is a difference between the predictability in the short horizon and the long horizon. Seyhun (1988), Huddart and Lang (2002) and Aboody, Hughes, Liu and Su (2006) conclude that aggregate insider trading activity is most commonly observed in the first three months before the fluctuations in the stock market start. This statement is confirmed by Finnerty (1976) and Jaffe (1974); their studies find that insiders earn significantly higher returns in the first few months after their trading. The opposite is proven by Seyhun (1992), who concludes that: The predictive ability increases with the length of forecasting horizon, months of past insider trading, and market sensitivity of the stocks and significantly exceeds the predictive ability of past stock returns or dividend yields. (p ). The 60-percent predictive ability, as stated in the previous section, is realized by taking a much longer horizon, like a year. This latter statement is confirmed by Lakonishok et al. (2001). They also find that, by taking a very short horizon such as three months, insider trading seems to predict very little when it comes to market returns. Rozeff and Zaman (1988) also agree on this; after the introduction of transaction costs, they find that the only horizon left for insiders to make a profit is the annual one. In contradiction to what is said earlier, Huddart et al. (2002) also concluded this result after they adjusted their research method. Next to the horizon there are two characteristics of insider trading which I examine. First there is a difference between purchases and sales; it seems that future stock returns are only related to purchases (Seyhun 1998; Rozeff et al., 1988). This is explained by the reason of trading; if an insider sells he can have many reasons to do so, but buying can only have one reason; making money (Lakonishok et al., 2001). Secondly, the amount traded by insiders is a very important piece of information to outsiders. Although Jaffe (1974) finds no evidence, Seyhun (1986) and Meulbroek (1992) present that there certainly is a relation between the volumes traded by insiders and the recognition of these trades by the market. Their results suggest that if insiders have potential access to more valuable information, these insiders on average trade a larger volume of stock. Volume is not the only characteristic of insider trading which seems to lead to incorporation into a stock s price; also the number of trades and trade direction are important aspects to investors. 6

7 Finally there is considered a distinction between the predictive ability of insiders with regard to smaller and larger companies. Prior studies find that insiders within larger firms seem to have little explanatory power in comparison to small firms (Seyhun, 1986, 1988, 1992; Rozeff et al., 1988). Insider trading activity in smaller firms seems to be more profitable, this can be reasoned in the following way: Managers in smaller firms possess more valuable information about the fortunes of their companies than do the managers of larger firms. Moreover, managers in smaller firms might have more freedom to exploit this information (Lakonishok et al., 2001, p. 94). But do insiders really trade on private information? B. PRIVATE INFORMATION As stated in the previous paragraph, insiders seem to have an advantage with regard to available information about the future prospects of a firm. It tends to be the case that, because insiders are closer to the daily routine within a company, they trade on more valuable information when comparing this to outsiders (Seyhun, 1986). In this section I provide an answer to the question if this statement can further be confirmed. Many studies investigate if insiders actually trade upon private information required by their position within the company. These studies come up with very conflicting findings about this statement. First of all, in the 80 s, Finnerty (1976) and Jaffe (1974) provide sufficient evidence about the successfulness of insider trading. They both find that insiders do have potential access to information that outsiders do not have. Furthermore, it seems that they use this special information to earn advantage and try to outperform the market. Later on, during the 90 s several studies (Rozeff et al., 1988; Elliot, Morse & Richardson, 1984; Givoly & Palmon, 1985) suggest that this evidence cannot be proved by their results. All their empirical findings suggest that insiders do not trade upon the use of private inside information. Rozeff et al. (1988) put a slight remark to their conclusions; they find that if insiders do possess private information, it is not proven that they profit from this advantage. Very contradicting to this again are studies published in the recent history. One of their results includes the following; Insiders possess, and trade upon, knowledge of specific and economically significant forthcoming accounting disclosures as long as 2 years prior to the disclosure (Ke, Huddart & Petroni, 2003, p. 315). This implies that, consistent with studies back in the 80 s, 7

8 insiders do use private information when trading which outsiders do not have. In addition to what is said above, Seyhun (1988) added an extra confirmation on the use of private information by insiders. He proves that after stock price movements, which are following news-announcements, insiders seem to reverse the direction of trading as they did before the news. It implies that insiders know about the upcoming news and that by concluding this, following insider trades can lead to an advantage to outsiders. To confirm this statement about the use of private information, four studies investigate the stock option exercise behavior of executives and employees. Three studies (Aboody et al., 2006; Brooks, Chance & Cline, 2009; Bartov & Mohanram, 2004) focused their research on the behavior of executives; these kinds of insiders seem to possess the most valuable information about the prospects of their firm. Their results indicate that executives seem to time their option exercises on the basis of their access to private information. Executives seem to hold on to their options when they possess positive information and exercise their options if the future looks negative. But is this also the case with regard to lower-ranked insiders? Huddart et al. (2002) investigate the exercise behavior of stock options by employees. They find strong evidence that information about the prospects of a firm is reflected in the exercise behavior of these insiders. This suggests that even lower ranked insiders have access to information concerning future stock returns. While it may be impossible to infer valuerelevant information from the exercise decisions of an individual employee, the aggregated exercise decisions of many employees do, on average, contain substantial information about firm prospects (Huddart et al., 2002, p. 36). Going back further to the source of the advantage executives can take from timing their exercise decisions, I look at the option award behavior by corporations which are grating the options to their executives. Lie (2004) and Yermack (1997) investigate the stock price behavior just before and after stock option awards by corporations. Both studies find evidence of favorable movements on the stock prices just after stock option awards, but could not find this while looking at the period before these awards. With respect to the latter result, Yermack (1997) said: I do not find a corresponding pattern of stock price moving downward in advance of option awards, as would be the case if option awards were delayed until after the disclosure of bad news. (p. 457). This implies that corporations time the option awards in a way that leads them to the greatest benefit for their executives. One of the possibilities which can cause the results above is the leakage of awarding-information to outside investors. By 8

9 this leakage markets will quicker anticipate on the information, which can lead to stock price movements. Chauvin & Shenoy (2001) introduce another view on the timing-advantages executives seem to have. They provide evidence of executives controlling the timing of good and bad news around their option granting dates, but this will later be discussed in the paragraph about voluntary disclosure strategies. Another possibility is that executives are effective in the timing of their option awards. Lie (2004) finds that executives do have this timing ability, and suggest that awards are timed just after a sharp drop in the stock price and before a reversal is taking place. This finding is confirmed by Yermack (1997) who provides the following evidence: Executives receive option awards at more favorable times if their companies have no predictable schedule for granting options. (p. 458). He also states that the success of their timing is caused by their influence over the committee that sets the gratingpolicy on stock options. With regard to this, a recent study from Bebchuk, Grinstein and Peyer (2010) states that high-level executives are granted with options which seem to be very lucky. They add that these lucky -grants are more likely to occur when the board of corporations exists off more dependent directors, because this board will eventually grant the options. C. REGULATION ON INSIDER TRADING Regulation on insider trading is introduced several years ago in order to control illegal insider trading. The regulation mainly implies that insiders, who are trading on the corporation s stock, are required to report their actions to the regulator or make them publicly disclosed themselves. If the insider does have potential access to material non-public information about the firm, the insider should either disclose this information or refrain from trading. Insider trading transactions are used by the market to incorporate private information into stock prices, by using the insider trades this incorporation happens on time and with accuracy. Meulbroek (1992) suggests that regulation on insider trading leads to less informative prices; regulation bans the insider trading and therefore causes stock prices to not reflect all possible information available. The influencing role of insiders on stock prices seems to be reduced by insider trading laws; insiders who are trading probably are the main disseminators of information about their firm. But, this reduced role leads to a more intensive collection of 9

10 information by other players in the market. Because of this collective information gathering, Fernandes and Ferreira (2007) find a somewhat different change than Meulbroek (1992) did. Fernandes et al. (2007) find an increase in stock price informativeness within countries that enforced the regulation on insider trading. The improvement on stock price informativeness, due to insider trading laws, seems to be concentrated in developed markets. The liberalization of equity markets, performed by these markets, occurs simultaneously with other improvements in a countries infrastructure. Reforms just as strong protection of shareholders rights, efficient legal systems, and good disclosure of information are causing an improving informativeness of stock prices in developed markets (Fernandes et al., 2007). This study also claims that within emerging markets, markets in countries with weak economic infrastructure, the implementation of regulation had no impact on the incorporation of information into stock prices. Yet another effect caused by the enforcement of insider trading laws is concentrated in analysts following the insider trades. It should be the case that an insider is followed by outsiders who do not possess private information about a firm. After all Bettis, Vickrey & Vickrey (1997) find evidence that an outsider, who mimics the transactions of insiders, could earn significant abnormal returns. But despite the above, Lakonishok et al. (2001) find that the market initially ignores the valuable information obtained by insider trading. It seems that in the period just after an insider trade, the market is under-reacting. Studies find evidence of an increase in analyst following insider trading due to the enforcement of insider trading laws. But this increase is concentrated in emerging markets. One study (Bushman, Piotroski & Smith, 2005) states the following about this: The increase in analyst following upon enforcement is significantly higher in emerging market countries and significantly lower in countries that have already liberalized their markets. (p. 53). The initial intention of regulation on insider trading is to reduce the wealth effects of insiders obtained by trading on stocks of their own firm. Garfinkel (1997) studies the effect of regulation and find that, by the enforcement of stricter laws, insiders are discouraged to trade on the advantage they have. This is confirmed by Gilbert and Tourani-Rad (2006) who investigate the effect of regulation in New-Zeeland. They prove that the 10

11 new laws effectively reduce the wealth effects on insider trading and forces the insiders to not gain any advantage on their possession of information about the company which outsiders do not have. Huddart et al. (2002) further investigate the impact and find a difference between senior managers and junior employees. Since senior managers are more restricted by insider trading laws, they are not able to reflect all the information they possess into their trading behavior. Employees tend to be less bothered by these laws. As said before, I also look at the impact of regulation on the exercise behavior by insiders. Carpenter et al. (2001) provide evidence on the effect of this regulation. They find that insiders use private information to time their exercises in the period before regulation was implemented, but do not find any evidence of this usage in the post-regulation period. This suggests that the insider trading laws are working in a way they were originally been introduced for. In addition to this, their research comes up with different findings concerning small and large firms and lower- and higher-ranked insiders. First it seems that: Smaller firms have higher post-exercise abnormal returns than larger firms in the pre-1991 regulatory regime and lower post-exercise returns in the post-1991 regime. (Carpenter et al., 2001, p. 18). This implies that the impact of regulation on smaller firms is much more effective in comparison to larger firms. Secondly it seems that higher-ranked insiders are more impacted by the regulation on insider trading. Their exercises in the period before regulation were preceded by higher abnormal returns when comparing these returns to the period just after the regulation was implemented (Carpenter et al., 2001). D. THE BID-ASK SPREAD A bid-ask spread presents the difference between the highest price a buyer is willing to pay for an asset and the lowest price for which a seller is willing to sell the asset. This bid/askspread is used as a measure for liquidity of the market and the size of transaction costs. But what does this have to do with insider trading? Because, as seen in previous paragraphs, insiders have informational advantage compared to outsiders, the market maker sets its bid-ask spread in such a way that he is protected from 11

12 systematic losses to informed traders. Copeland and Galai (1983) stated that a market maker always sets a higher ask and a lower bid price than what he believes the market price should be. By this, the bid-ask spread is reflecting the expected loss to inside traders (Seyhun, 1986). This latter statement is confirmed by Glosten and Milgrom (1985) and Chae (2005); both studies find a higher bid-ask spread when the market maker knows about the presence of informed traders within a certain market. Results from Chung and Charoenwong (1998) show that there is no significant different change in bid-ask spreads around insider trading days when comparing this change to other days. This implies that market makers cannot detect insider trading, but protect themselves when they suspect insider trading to a greater extend. As stated above, market makers set larger spreads for stocks within a market where more insider trading transactions occur. But despite this extent of insider trading there are more aspects which will affect the width of the bid-ask spread. One of these aspects covers the total volume of trade. Market makers seem to be unable to detect insider trading when it occurs, so they try to get their information from somewhere else. Chung et al. (1998) find that insiders seem to hide their trades on days when a high volume of stocks trades. This explains why market makers set larger spreads in case of higher trading-volume. Seyhun (1986) and Glosten et al. (1985) confirmed the latter sentence and state that the bid-ask spread increases by an increase in trading volume. Yet another aspect which is used by market makers to set their bid-ask spreads is quality of disclosures and the relation to this with the number of analysts following the firm. Frankel and Li (2004) find that analysts coverage is decreasing with an increase in a firms quality of disclosure. Because Chang, D Anna, Watson and Wee (2008) find a decrease in bid-ask spreads at the time disclosure quality increases and Bushman et al. (2005) find smaller bid-ask spreads for firms which are highly followed by analysts, it seems that both offset each other and affect the bid-ask spread in the same direction. Roulstone (2003) and Clarke and Shastri (2000) verify this statement and find a smaller bid-ask spread for firms which are highly informative to outsiders. The high informativeness could be caused by analysts or themselves. Other aspects which can lead to a change in bid-ask spreads are firm size and board characteristics. Seyhun (1986) concludes a fall in losses to insiders within smaller firms, this implies smaller bid-ask spreads set by market makers. Latter statement is verified by Schultz (1983) and Stoll and Whaley (1983), both studies find a negative relation between firm size 12

13 and the bid-ask spread. Kanagaretman, Lobo and Whalen (2007) investigate board characteristics which will affect the spread set by market makers. They provide evidence of smaller increases in spreads around disclosure dates when there is greater board independence and board activity within a firm. This implies that market makers are more at ease when the board of a firm is highly controlling the insider trading activities. i. INFORMATION ASYMMETRY Next to the aspect described above, I investigate what information asymmetry has to do with the bid-ask spread. Information asymmetry implies a difference in the quality of information one party has when comparing this to another party. To simplify; one person (an insider) has more and better information about a firm than another person (an outsider). Several studies (Frankel et al., 2004; Venkatesh & Chiang, 1986; Copeland et al., 1983; Glosten et al. 1985; Kyle, 1985) investigate the relation between information asymmetry. All studies find that market makers should increase their spreads when the degree of information asymmetry is increasing. By adjusting the spread market makers can reduce their losses to informed traders. As said above, the bid-ask spread changes with the degree of information asymmetry. But what determines the level of information asymmetry? First of all, the level of information asymmetry relates to the disclosure quality of a firm. Firms which are timely disclosing value relevant information to outsiders tend to have less information asymmetry when comparing to other firms (Brown & Hillegeist, 2007; Frankel et al., 2004). Besides this disclosure quality Aboody and Lev (2000) investigate research and development (R&D) activities as a measure for information asymmetry. Their study reveals that insiders tend to gain more from their trades within companies which are R&D-intensive when comparing to firms that do not have R&D-activities. They conclude; R&D is thus a major contributor to information asymmetry and insider gains (p. 2747). Aboody et al. (2000) also look at the disclosure of insider trades in relation to the investors reaction to this. They find that investors tend to react more strongly when R&D-intensive firms are disclosing their insiders trades. R&D-intensive firms contain more private information; this offers great information asymmetry which can be minimized by observing insider trades. Other proxies for information asymmetry are; number of analysts following, firm size, number of competing traders, volume of trade and investment opportunity-sets of a firm (Frankel et al., 2004; Aboody et al., 2000; Clarke et al., 2000; Chae, 2005) 13

14 ii. CORPORATE POLICIES Many firms are trying to reduce the wealth effect of insider trading by restricting trading around certain value relevant announcement-dates. Such a policy is called a blackout-period; a period before and after scheduled news-announcements in which it is not allowed for an insider to trade. Bettis, Coles and Lemmon (2000) investigate the effectiveness of this blackout-period and fund that trading within these periods is generally less profitable than allowed insider trading before and after these blackout-periods. They further suggest that, because of this effectiveness, the bid-ask spread becomes narrower by about two basis points. Jeng (1997) (as sited in Bettis et al., 2000) in principal verifies this statement, but concludes a somewhat smaller effect of only one basis point. In contradiction to this, Jagolinzer, Larcker and Taylor (2011) find that profits from insider trading are definitely higher when trading occurs within the restricted trading windows. They also explain that since the period ( ) studied by Bettis et al. (2000) the regulation on insider trading changed and became less effective in reducing insider trading profits within blackout-periods. But in agreement with Bettis et al. (2000), Roulstone (2003) find that firms themselves seem to acknowledge less profitable insider trades when they implement corporate policies restricting these trades. He also finds a positive relation between firms restricting insider trading and the level of compensation; restricted insiders receive 2,5% more on total compensation when comparing to unrestricted insiders. E. VOLUNTARY DISCLOSURE Within this paragraph I talk about voluntary disclosure and all concerns related to this aspect of insider trading. Voluntary disclosure is about managers voluntary revealing information to the outside world in order to prevent outsiders to find out themselves. Another reason for managers to voluntary disclose information is to discourage information revelation by other competing informed traders (Bushman & Indjejikian, 1995), by this they try to keep an informational advantage in order to maximize their trading profits. The latter statement implies more disclosures if the firm is facing increasing inside traders (Narayanan, 2000). But 14

15 increasing disclosure will also enhance a threat. When there is more information revealed, this revelation will also be more likely to include important information to outsiders. Before looking at voluntary disclosure strategies and insider trading profits, I first examine the markets reaction to these disclosures. Gu and Li (2007) investigate this aspect and find that investors react positive to disclosure; they think the disclosure contains credible news. They also find that this reaction to disclosure tends to be stronger when disclosure is preceded by insider trading transactions, especially purchases. Investors think the pre-disclosure transaction enhances the credibility of the disclosure, this way of thinking relates to greater abnormal returns in the post-disclosure period. Gu et al. (2007) also investigate the kind of firms with greater credibility-enhancing effects and state the following: The credibility-enhancing effect of insider purchase signals is greater for younger firms, firms with lower analyst following, firms reporting losses, and firms with higher R&D intensity. This evidence indicates that the signal of insider purchase is more useful to investors when insiders are privy to a greater amount of valuable information (p ). Many studies investigate voluntary disclosure strategies used by managers to increase their profits from insider trading. For example, Benabou and Laroque (1992) find that many insiders can and will manipulate the information they disclose in order let their inside transactions move in a more favorable way. Another strategy to increase trading profits is highlighted by Cheng and Lo (2006); they find that managers disclose more bad news when they intend to buy shares. This statement is confirmed by Aboody and Kasznik (2000) who find that insiders make opportunistic disclosures to increase their profits from stock option awards. Chauvin et al. (2001) also investigate disclosures around option grants and confirmed the above by providing evidence of information being manipulated in the pre-granting period. But looking from the other way around, Cheng et al. (2006) find that managers are not only professionals in disclosing the right information at the right time, but also in timing their trades. They find that managers are strategically timing their purchases and sales around news disclosure-dates to maximize their wealth effects from insider trading. Noe (1999) performs extensive research on this and finds evidence consistent with the above, but made a slight remark on this. He states that managers seem to be very careful to not get suspicious; when there is no proof of not trading on non-public information they are violating the law. Because of this, Noe (1999) investigates this aspect and indeed finds that managers seem to be very 15

16 careful not to trade just prior to important news-announcements. After all, within the period beyond the news-announcements information asymmetry will still be present and allows the insiders to still profit from their informational advantage at the expense of uninformed traders (Bushman et al. 1995). i. PATENT-ANNOUCEMENTS Next to the content of voluntary disclosure described above, I specifically talk about disclosure in the case of patent. Lansford (2006) performs extensive research on these patentannouncements and finds that these kind of announcements seem to be very worthy in the case of insiders with strategic disclosure plans to maximize their wealth effects. He further elaborates on this by providing evidence on the timing of these patent-announcements. He finds that the announcements are timed just before an upcoming disappointing earningsannouncement and states that this timing successfully controls the stock prices by reducing the response to this earnings disappointment. Graham, Harvey and Rajgopal (as cited in Lansford, 2006) confirm these findings by suggesting that the markets response to disappointing financial indicators can be tempered by good performing non-financial leading indicators. Another study (Ahuja, Russell & Lee, 2005) shows that managers seem to trade in their own corporations stock approximately one year before a patent-announcement. They also state that the previous is not that surprising: Since the information asymmetry between investors and managers should be greatest when assembling a patent application. This is the point at which knowledge is often first codified and the implications become apparent to managers but the information is still unavailable to investors (p. 802). This The information asymmetry can be used, as described before, to earn substantially large returns by trading on the corporation s stock. ii. 10B5-1 PLANS Rule 10b5-1 is enacted by the Securities and Exchange Commission (SEC), in the United States of America, in order to resolve an issue regarding insider trading. It states that insiders are violating the law when they have potential access to material, non-public, information about a firm when trading on this firms stock. Even if this insider did not intend to trade upon this information, it will be difficult to prove that the information did not influence his decision 16

17 to trade. However, the SEC added a defense for inside traders; the so called 10b5-1 plan defense. If, for example, a CEO plans to perform a trade in three months but finds out terrible news about his firm in two months from now which will me be made public in four months, this CEO will still go forward on his trade. By using his initial plans as a defensive, he can prevent himself from being accused of illegal insider trading under rule 10b5-1. Despite all the described above, Jagolinzer (2008) investigates the 10b5-1 plans and finds that participants, on average, have greater association with decreasing stock prices in the future when comparing to non-participants. This implies that there certainly is a strategic trade opportunity for insiders acting under rule 10b5-1. Henderson, Jagolinzer and Muller (2011) are consistent with these findings and additionally suggest that the disclosure of 10b5-1 plans even enhance the wealth effects of insider trading. Their evidence reveals that participants outperform non-participants, which suggests that rule 10b5-1 is not working properly. F. MARKET EFFECTS The last paragraph is about the effect which trading within option and credit markets has on the original underlying stock market. The effect of trading within the option market is discussed primarily, in the end there is a concise description of the effects of trading within the credit market. However, at first I take a look at the relation between the option and stock market as discussed in Easley, O Hara and Srinivas (1998). They find that future stock returns can be predicted by the volume traded within the option market in the past. With regard to this they stated the following: Our main empirical result is that negative and positive option volumes contain information about future stock prices (p. 431). John, Koticha, Narayanan and Subrahmanyam (2001) confirmed this finding and added a comment on this statement; they find that the predictive power of option trading is greater for options with large deltas. This is the case because insiders prefer to trade on these kinds of options. Trades within and the introduction of the option market seem to have a major impact on the underlying stock market. De Jong (2001) finds evidence of some positive effects of option trading on this market. He states that market makers very closely look at trading within the option market and use these trades to increase efficiency in the underlying stock market by 17

18 setting more accurate prices. This evidence is consistent with findings of several other studies (Copeland et al., 1983; Glosten et al., 1985; Fedenia & Grammatikos, 1992). These studies come up with identical evidence of a decrease in the stock s bid-ask spread set by the market makers just after trading within the option market occurred. This is the case because trading within the option and stock market is based on different information, so more information is revealed to the market by option trading when comparing it to just trading in the stock market (Back, 1993). Another positive effect presented by De Jong (2001) is that option trading increases the speed of information incorporation into underlying stock prices; the more option trading the faster the underlying stock price will be at his true price. This evidence is supported by Jennings and Starks (1986) who find that information is more rapidly reflected in option prices when comparing this to original stock prices. In addition to the option trading effect, also the initial introduction of the option market had certain effects on the underlying stock market. Next to previous effects, as described above, option listing reduces the volatility of the underlying stock market (Fedenia et al., 1992; Conrad, 1989; Skinner, 1989). But together with Stephan and Whaley (1990), De Jong (2001) also find a negative effect of option trading on the underlying stock. It seems that when option listing occurs, insiders are more motivated to trade within the underlying stock. This leads to smaller liquidity in the stock market and eventually market makers have to widen their bidask spreads. Biais and Hillion (1994) present another negative effect of option listing, they suggest the following: The introduction of the option enlarges the set of trading strategies the insider can follow. This can make it more difficult for the market makers to interpret the information content of trades and consequently can reduce the information efficiency of the market (p. 743). Next to effects from option trading, I also look at the effects of trading in credit derivatives. Acharya and Johnson (2007) provide significant evidence of an information flow from credit markets to the stock market. They suggest that prices in the credit market seem to quicker contain relevant information, which means that credit prices can predict future stock prices. The study, as presented above, also states that this information flow is established by the lower detection-risk within credit markets. Credit markets are not under surveillance all the time and are therefore less transparent, by this insiders will prefer trading in credit markets which leads to narrower bid-ask spreads in the underlying stocks (Bloomfield & O Hara, 1999). 18

19 III. SUMMARY AND CONCLUSIONS After doing research on several aspects of insider trading, I conclude that the informativeness of insider trading seems to be very extensive. It seems that insider trading can be used to predict future stock returns. Although one study, Chakravarty and McConnell (1999), proves no relation, several other studies actually provide sufficient evidence of a significant relation between insider trading activities and future stock returns. This predictive ability changes with length of horizon, direction of trading, volume traded and the size of the firm wherein the insider is trading. Next there is the question about if insiders possess and trade upon information about a firm which outsiders do not have. Studies come up with very conflicting findings as the time progresses. Studies during the 80 s find that insiders do possess and trade upon private information, during the 90 s this is not proved, but within the recent history several studies again confirm the statement. This possession of private information is further being proved by studies on awarding options by firms and exercising options executives and employees. It seems that option grating and exercising is very well timed by these insiders, which implies their knowledge about the firms prospects. After the possession of private information, there is a discussion about regulation on insider trading as well as the impact this regulation has on insider trading activities and the overall market. It seems that regulation on insider trading increases stock price informativeness, but this improvement is only concentrated in developed markets. Next to this informativeness, I investigate whether regulation has sufficiently reduced the wealth effects on insider trading. Several studies prove that regulation successfully reduces these wealth effects, on which the regulation eventually is introduced for. Another aspect is about the impact of insider trading on bid-ask spreads set by market makers. Several aspects influence the width of this spread; higher volume of insider trading, better information quality, more analysts following and bigger firms. All these aspects consequently make the market makers to increase their spreads. Information asymmetry and corporate policies also seem to affect the width of the spread; higher information asymmetry and weaker corporate policies lead to a wider spread. 19

20 It seems to be proven that managers can and will use their opportunity of voluntary disclosure as a strategy to manipulate the market. But Noe (1999) finds that managers seem to be very careful not to be trading just before important news is released. In addition, two types of voluntary disclosure strategies are discussed within this chapter. It seems that managers earn substantially large returns by trading on the corporation s stock prior to a patentannouncement; managers seem to notice these upcoming patents while outsiders have no clue about what s going on. Managers also seem to time patent-announcement around other, negative, announcements in order to successfully reduce the response to the bad news. Rule 10b5-1 -plans are another way on strategically disclosing information. These plans are very successful in increasing wealth effects to the traders, something which the rule not initially is designed for. Finally, the effects of trading within option and credit markets on the original underlying stock market are examined. Several studies provide sufficient evidence on option trading and listing having impact on the original stock market. Option trading and listing seems to; increase efficiency, narrow bid-ask spreads and increase informativeness of the underlying stock market. Also credit markets seem to be an informational source to the stock market, Bloomfield and O Hara (1999) concluded that trading in credit markets leads to narrower bidask spreads in the underlying stock market. 20

21 IV. LIST OF REFERENCES Aboody, D., Hughes, J., Liu, J., Su, W., Are Executive Stock Option Exercises Driven by Private Information. Review of Accounting Studies 13, Aboody, D., Kasznik, R., CEO stock option awards and the timing of corporate voluntary disclosures. Journal of Accounting and Economics 29, Aboody, D., Lev, B., Information Asymmetry, R&D, and Insider Gains. The Journal of Finance 55, Acharya, V., Johnson, T., Insider trading in credit derivatives. Journal of Financial Economics 84, Ahuja, G., Coff, R., Lee, P., Managerial Foresight and Attempted Rent Appropriation: Insider Trading on Knowledge of Imminent Breakthroughs. Strategic Management Journal 26, Back, K., Asymmetric Information and Options. The Review of Financial Studies 6, Bartov, E., Mohanram, P., Private Information, Earnings Manipulations, and Executive Stock-Option Exercises. The Accounting Review 79, Bebchuk, L., Grinstein, Y., Peyer, U., Lucky CEOs and Lucky Directors. Journal of Finance 65, Benabou, R., Laroque, G., Using Privileged Information to Manipulate Markets: Insiders, Gurus, and Credibility. The Quarterly Journal of Economics 107, p Bettis, J., Coles, J., Lemmon, M., Corporate policies restricting trading by insiders. Journal of Financial Economics 57, Bettis, C., Vickrey, D., Vickrey, D., Mimickers of Corporate Insiders Who Make Large-Volume Trades. Financial Analysts Journal (September/October), p

22 Biais, B., Hillion, P., Insider and Liquidity Trading in Stock and Option Markets. The Review of Financial Studies 4, Bloomfield, R., O Hara, M., Market Transparency: Who Wins and Who Loses? The Review of Financial Studies 12, 5-35 Brooks, R., Chance, D., Cline, B., Private Information and the Exercise of Executive Stock Options. Working Paper Series, University of Alabama. Brown, S., Hillegeist, S., How Disclosure Quality Affects the Level of Information Asymmetry. Review of Accounting Studies 12, Bushman, R., Indjejikian, R., Voluntary Disclosures and the Trading Behavior of Corporate Insiders. Journal of Accounting Research 33, Bushman, R., Piotroski, J., Smith, A., Insider Trading Restrictions and Analysts Incentives to Follow Firms. The Journal of Finance 60, Carpenter, J., Remmers, B., Executive Stock Option Exercises and Inside Information. Journal of Financial Economics 48, Chae, J., Trading Volume, Information Asymmetry, and Timing Information. The Journal of Finance 60, Chang, M., D Anna, G., Watson, I., Wee, M., Does Disclosure Quality via Investor Relations Affect Information Asymmetry. Australian Journal of Management 33, Chakravarty, S., McConnell, J., Does Insider Trading Really Move Stock Prices. The Journal of Financial and Quantitative Analysis 34, Chauvin, K., Shenoy, C., Stock price decreases prior to executive stock option grants. Journal of Corporate Finance 7, Cheng, Q., Lo, K., Insider Trading and Voluntary Disclosures. Journal of Accounting Research 44,

23 Chung, K., Charoenwong, C., Insider Trading and the Bid-Ask Spread. The Financial Review 33, Clarke, J., Shastri, K., On Information Asymmetry Metrics. Working Paper, University of Pittsburgh. Conrad, J., The Price Effect of Option Introduction. The Journal of Finance 44, Copeland, E., Galai, D., Information Effects on the Bid-Ask Spread. The Journal of Finance 38, Cziraki, P., De Goeij, P., Renneboog, L., Insider Trading, Option Exercises and Private Benefits of Control. CentER Discussion Paper, Tilburg University. Degryse, H., De Jong, F., Lefebvre, J., An Empirical Analysis of Legal Insider Trading in the Netherlands. Working paper, Tilburg University. Diamond, D., Optimal Release of Information By Firms. The Journal of Finance 40, Du, J., Wei, S., Does Insider Trading Raise Market Volatility. The Economic Journal 114, Easley, D., O Hara, M., Srinivas, P., Option Volume and Stock Prices: Evidence on Where Informed Traders Trade. The Journal of Finance 53, Elliot, J., Morse, D., Richardson, G., The Association between Insider Trading and Information Announcements. The RAND Journal of Economics 15, Fedenia, M., Grammatikos, T., Option Trading and the Bid-Ask Spread of the Underlying Stocks. The Journal of Business 65, Fernandes, N., Ferreira, M., Insider Trading Laws and Stock Price Informativeness. Review of Financial Studies 14,

24 Finnerty, J., Insiders and Market Efficiency. The Journal of Finance 4, Frankel, R., Li, X., Characteristics of a firm s information environment and the information asymmetry between insiders and outsiders. Journal of Accounting and Economics 37, Garfinkel, J., New Evidence on the Effects of Federal Regulations on Insider Trading: The Insider Trading and Securities Fraud Enforcement Act (ITSFEA). Journal of Corporate Finance 3, Gilbert, A., Tourani-Rad, A., The Impact of Regulations on the Informational Basis of Insider Trading. Australian Journal of Management 33, Givoly, D., Palmon, D., Insider Trading and the Exploitation of Inside Information: Some Empirical Evidence. The Journal of Business 58, Glosten, R., Milgrom, P., Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders. Journal of Financial Economics 14, Graham, J., Harvey, C., Rajgopal, S., The Economic Implications of Corporate Financial Reporting. Working Paper, Duke University. Gu, F., Li, J., The Credibility of Voluntary Disclosure and Insider Stock Transactions. Journal of Accounting Research 45, Henderson, M., Jagolinzer, A., Muller, K., Strategic Disclosure of 10b5-1 Trading Plans. Working Paper University of Chicago. Huddart, S., Lang, M., Information Distribution Within Firms: Evidence From Stock Option Exercises. Journal of Accounting and Economics 34, Jaffe, J., Special Information and Insider Trading. The Journal of Business 3, Jagolinzer, A., SEC Rule 10b5-1 and Insiders Strategic Trade. Management Science 55,