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What Do Insiders Know? The Informational Content of Insider Trading around Three Corporate Events.

Ye, X (2022). What Do Insiders Know? The Informational Content of Insider Trading around Three Corporate Events.. (Unpublished Doctoral thesis, City, University of London)


Corporate insiders, such as CEOs, CFOs and other senior managers, are commonly recognised in the stock market as possessors of private information about the future prospects of their company. These high-rank managers are informed investors because they are closely involved in the daily operations of their firms and have superior access to price-sensitive information than outside investors. They frequently execute open market transactions to purchase or sell shares. They do so for various reasons. They trade legally if they consider their firm is mispriced or to execute stock options the board rewarded them to align their incentives with the shareholders’. However, regulators strictly prohibit corporate insiders to trade the shares of their companies based on any material private information. Nevertheless, previous literature has unanimously documented a robust return predictability embedded in their trades, indicating corporate insiders frequently trade on their private information for personal monetary gain (Seyhun, 1988; Lakonishok and Lee, 2001; Roulstone, 2003; Ravina and Sapienza, 2010; Cohen, Malloy, and Pomorski, 2012). Whilst many previous studies in the last decade attempt to understand the motivation behind these informed transactions, the issue is still contentious and there is ongoing debate concerning the determinants, the legality, the timing, and the profitability of insider trading.

Motivated by the recent advancement in the insider trading literature, the objective of this thesis is threefold. First, to investigate the incentives for corporate insiders to make more informed transactions around three pivotal events: (i) CEO turnover, (ii) M&A announcements of their supply-chain firms, and competitors and (iii) when their firm’s stock price reaches its 52-week high/low. I use a large sample of insider trades announcements spanning 25-year from the US. I focus on both the changes in trading activity and profitability in response to these three events.

Second, to assess the informational content behind these more informed insider transactions to better understand the implications of these events for their firms. Existing literature has contradictory predictions for the impact of these corporate events on future firm performance. I employ insider trading activity as an indicator to examine these predictions because insiders have the advantage to understand better their firms’ growth prospects, and their decision and post-transaction profitability are viewed as a function of the impact attributed to these events on their firm’s future performance on which their personal wealth is hinged.

Third, to empirically test and bridge tournament incentives, M&A, and behavioural finance literature with the insider trading literature. The thesis not only contributes to the insider trading literature but also to these three different streams of literature. Tournament incentives and insider trading literature both study the managers’ behaviours, the ongoing investigations in these two domains are largely parallel and do not intersect. To the best of my knowledge, the second chapter is the first empirical analysis to bridge these two streams of literature. Similarly, the existing M&A literature mostly focus on the insider trading activity either in the acquirer or target firms (Agrawal and Nasser, 2012; Fidrmuc and Xia, 2021; Davis et al. 2021). My third chapter is the first to focus on insider trading activity in a firm that is not directly involved in the M&A deal, but the protagonists are in its supply chain either as a competitor, supplier, or customer. Lastly, the fourth chapter challenges and revises an existing finding in the behaviour finance literature that corporate insiders, who are informed investors, also suffer from the 52-week high anchoring bias. I further analyse whether corporate insiders trade in the direction predicted by the existing literature or do they behave differently because they have private access to the future fundamentals of their firms.

The research findings in the second chapter indicate that non-CEO corporate insiders who have lost their promotion opportunity to the next CEO actively sell their shares in their own company. They trade on their private negative information to make higher loss-averting abnormal return. The empirical results are consistent with the prediction of tournament incentives model that senior executives endure pay below the optimal market rates because they incorporate the implicit value of the future promotion opportunity into their contracts. Once the expected value of the implicit compensation has drastically declined, these senior executives trade to compensate themselves for the forgone incentives. I subject my results to various robustness checks. I find that they undertake loss-averting sell trades when their pay gap with the CEO is high, they are relatively young with short-term horizon, and when their firm’s governance is comparatively weak. I show that they trade on their firm’s future declining performance, increase in its cost of capital, and worsening in investor sentiments. My results also show that this trading opportunity weakens the well-documented positive relationship between tournament incentives and firm performance. The conclusion indicates that having a large pay disparity between CEO and other senior managers is not as effective and efficient as the literature has so far documented. Moreover, my results imply that regulators need to focus also on the non-CEO executives who appear to trade on insider information with relatively low regulatory risk.

The third chapter shows that that corporate insiders significantly alter their trading activities and make more informed transactions when their competitors or customers firms become an M&A target. The results show that corporate insiders recognise that their operating and innovation efficiencies will be improved attributed to the M&A deal, and they will increase their holdings to benefit from the better firm performance. I further show that corporate insiders not only have informational advantage in private information but can understand public information better than outside investors. Their trades also predict their firm’s potential takeover bid. I subject my results to a battery of robustness test and find that incomplete M&A announcements do not lead to the significant change in both insider trading activity and profitability. Moreover, insider trading measure can predict the probability of the deal completion, and the predictive power is in addition to the market-estimated probability.

The fourth chapter focuses on insider trading around the 52-week high/low. Previous studies concluded that the aggregate investors suffer from the 52-week high/low anchoring biases as they are more likely to sell high and buy low, and corporate insiders who are conventionally viewed as informed traders, are not exempt from the bias. In contrast, I find that insiders systematically trade at these price extremes, but they do not suffer from anchoring biases. Some insiders, such as male, CEOs and opportunistic insiders employ dissimulation strategies to conceal their informational advantage and engage in highly profitable transactions. A longshort strategy based on a portfolio built on the top decile 52-week high (low) recency of their transactions generates an annual abnormal return of approximately 31%.

Studies on insider trading are subject to several limitations. First, it is not clear why insiders trade. They may do so to take advantage of their private information, to correct misevaluation or for liquidity and portfolio diversification motives. I use in all my chapters various econometric specifications, including diff-in-diff and IV methods to mitigate any bias driven by reverse causality. I also account for insiders’ sequential transactions and dissimulation strategies to mitigate regulatory risk. In Chapter 4, I undertook an out of sample test by assessing insiders’ trading propensity and profitability during the COVID period when many stocks reached their 52-week low. I find that, overall, my results hold to all these specifications. Second, this study does not investigate other than the US insider trading regulation systems, which are relatively similar but differ in their implementations (Bhattacharya and Daouk, 2002). Third, I do not assess insiders’ personal attributes as in Hillier, Korczak and Korczak (2015), beyond their gender, because of data unavailability. The extent to which these limitations will alter or confirm my US results is the subject of further research.

Publication Type: Thesis (Doctoral)
Subjects: H Social Sciences > HG Finance
Departments: Bayes Business School > Bayes Business School Doctoral Theses
Bayes Business School > Finance
Doctoral Theses
Text - Accepted Version
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