Impacts of insider trading

Abstract

This dissertation examines the impacts of the insider trading phenomenon in Hong Kong. Traditionally, insider trading activity has been viewed as a proof of market efficiency in a strong form level. Evidence from the various markets all over the world has demonstrated that insider trading (legally and illegally) can bring in abnormal profits for the traders. Earlier insider trading literature examines the timing of insider trading activity and the magnitude of the abnormal returns to corporate events such as mergers and acquisitions, rights issues and earnings announcements. More recent papers focus on the effects of insider trading activity on overall market returns and market microstructure issues such as liquidity. Insider trading has been widely explored in the US, the UK and Canadian markets where there is a long history of regulated insider trading activity. While most of the literature evaluates insider trading behavior in the US and Europe, empirical evidence in this area concerning the other markets is limited. The recent implementation of regulations allowing and governing insider trading activity in other markets provides opportunities for research studies on insider trading under different market settings such as Norway, Australia, Spain, Singapore and Hong Kong. This dissertation attempts to provide an overall picture of the insider trading activity and its effects to firms and the market in Hong Kong. The Hong Kong market is chosen for examination because the market setting, legal environment and corporate structure in Hong Kong are different from those of the more developed markets such as the US and the continental Europe: 1.Hong Kong is an emerging market. The degree and speed of inside information dissemination may be different from those in developed markets. 2.The disclosure requirement between Hong Kong and the US are different. 3.The directors in Hong Kong are frequent and heavy traders. 4.The corporate structure in Hong Kong is different from that of the US as many listed firms in Hong Kong are controlled by families. There are four independent but related essays in this thesis which evaluates the directors' dealings in four different aspects, namely, (1) the magnitude and determinants of insider trading activity; (2) the effects of aggregate insider trading activity on market movement; (3) the liquidity effects of insider trading; and (4) the insider trading activity around corporate share repurchases. The logic of the essay sequence is as follows: First some overall statistics to identify relevant determinants of insider trading activity in Hong Kong are provided. Then the effects of insider trading activity on the whole market are evaluated. Afterwards, the dissertation takes a micro-perspective view by looking at its effects on liquidity at the firm levels. Finally, a corporate event (share repurchase) is selected and its relation to insider trading and their transaction effects are examined. This design attempts to provide a comprehensive picture about the impacts of insider trading from various angles. Summary of the four essays are as follows: Essay One: Insiders' Dealings in an Informationally Asymmetric Environment The information asymmetry hypothesis argues that insiders are motivated by signaling function, insider profits or liquidity preference to trade in the market. Therefore, Essay 1 addresses the signaling impact of directors' dealing in an informationally asymmetric environment like Hong Kong. Both the short-term and long-term abnormal share price reactions of the insider trading firms are examined. Furthermore, the relations between insider trading activity and various information asymmetry proxies are examined. The results are: 1.There are small but statistically significant short-term abnormal returns over a period of 60 trading days. 2.Sale is a more effective signal to predict future decrease in share price. 3.Higher insider trading profits are related to higher proportion of informed trading to total trading volume, smaller size firm, lower directors' share ownership and higher trading frequency. 4.The likelihood of insider trading is higher if there are higher proportion of intangible assets, better earnings performance, smaller sales value and higher variation in trading volume. Essay Two: Do Insiders Have "Inside Information" on Aggregate Market Returns ? The insider trading literature documents that informed trading of a given firm can predict firm-specific future share price movement for the firm concerned. However, if the general market movement is a reflection of the share price changes of all firms in the market, it is possible that insider trading, in aggregate, can predict future market return. Therefore, Essay 2 assesses the aggregate signaling impact of insider trading on the future market movement as a whole to see if insider trading can facilitate the pricing efficiency of both the firms and the market comprehensively. The results are: 1.The vector autoregressive (VAR) analysis shows that aggregate insider trading activity Granger-causes market return. 2.The informativeness of the aggregate insider trading activity to predict subsequent market return depends on the time horizon under examination. The shorter the time horizon, the stronger the predictive power of the insider trading activity is. 3.Lagged insider sales possess relatively more information content than lagged insider purchases. Essay Three : Do Insiders Provide Liquidity? As insiders are in possession of confidential information, most insider trading studies focus on the profit-making motive of insiders. However, the information asymmetry model of market microstructure suggests that the presence of informed trading in the market would change the liquidity behaviour of the market. Therefore, one of the issues in the liquidity and insider trading literature is whether insider trading would enhance or impair market liquidity. Essay 3 explores the resultant impact of directors' dealing on the liquidity pattern of the firms. The results are: 1.There are lower spread and higher depth on insider trading days than on non-insider trading days, suggesting that insider trading activity improves market liquidity. 2.The change in liquidity behaviour is affected by how heavily the shares are traded by the informed directors. Higher relative spread and lower depth are found as the proportion of informed trading increases. 3.The adverse selection cost analysis shows that the presence of directors' dealings enhances market liquidity by reducing the adverse information cost. Essay Four : Double Signals or Single Signal ? An Investigation of Insider Trading Around Share Repurchase According to the information asymmetry hypothesis, insiders have private information about the current mispricing and future prospects of the firms. Therefore, it is not surprising that the insiders would trade before a financial event. In the insider trading literature, many studies have been conducted to investigate the relation between insider trading activity and corporate announcements. Since both share repurchase and directors' dealing can be motivated by the information signaling purpose, Essay 4 examines the simultaneous signaling impacts of share repurchase and directors' dealing to evaluate the relative pricing effects and credibility of the undervaluation message. The results are: 1.The directors' purchase activity around the share repurehasing period is significantly lower than the expected level while the directors' sale activity is abnormally higher than the expected level. 2.The "Repurchase Only" subsample earns higher abnormal returns than the "Repurchase and Buy" subsample which earns higher returns than the "Repurchase and Sell" subsample. 3.The Tobit model provides no evidence that information signaling is a dominant factor driving share repurchase decision. In short, most of the results from the four essays are consistent with the views of the literature and some of the results are peculiar due to the different market setting, legal environment and corporate structure in Hong Kong.