Time‐Varying Liquidity Trading, Private Information and Insider Trading

• Author: Xuewu Wang,Qin Lei
• Date: 01 March 2014
• Published date: 01 March 2014
• DOI: http://doi.org/10.1111/j.1468-036X.2011.00634.x

European Financial Management, Vol. 20, No. 2, 2014, 321–351

doi: 10.1111/j.1468-036X.2011.00634.x

Time-Varying Liquidity Trading,

Private Information and Insider

Trading

Qin Lei

Finance Department, Cox School of Business at Southern Methodist University, 6212 Bishop Blvd,

Dallas, TX 75275-0333, USA

E-mail: leiq@umich.edu

Xuewu Wang

Department of Economics and Finance, Kania School of Management at the Universityof Scranton,

320 Madison Avenue, Scranton, PA 18510, USA

E-mail: xuewuw@umich.edu

Abstract

This paper investigates the insider trading before scheduled versus unscheduled

corporate announcements to explore how corporate insiders utilise their private

information in response to the time-varying liquidity trading. Using a compre-

hensive insider trading database, we show that: (1) the insider’s propensity to

trade increases in the amount of liquidity trading before both the scheduled and

unscheduled announcements; (2) insiders buy (sell) morebefore positive (negative)

announcements; and (3) insider purchases are more profitable before unscheduled

announcements than before scheduled ones. They suggest that insiders time their

trades around scheduled and unscheduled announcements to exploit the varying

extent of liquidity trading.

Keywords: time varying,liquidity trading,insider trading

JEL classification: G10, G14

1. Introduction

One fundamental question in the field of market microstructure is how private

information gets incorporated into asset prices through the trading process. It is

now generally accepted that such private information is often revealed through orders

The authors are grateful to John Doukas (the editor) and an anonymous referee for their

insights that greatly strengthened the paper. The authors also thank participants at the FMA

2010 meeting in New York and especially Bonnie Van Ness (the discussant) for their helpful

comments and suggestions.

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from informed traders and through learning these orders by other market participants

such as market makers and uninformed traders. From this perspective, studying the

interaction between informed traders and uninformed traders (also known as liquidity

traders) is especially important for a better understanding of the private information

incorporation process. Approximating corporate insiders as informed traders, this paper

studies insider trades around two distinct settings, i.e., scheduled versus unscheduled

corporate announcements, to investigate how insiders trade differently based on their

private information when there is a dispersion in the amount of liquidity trading around

such announcements.1

Scheduled and unscheduled announcement events are distinguishable by the public

availability of the timing information as to when an announcement will be issued.

Scheduled announcements are those where such information is publicly available in

advance whereas unscheduled announcements refer to cases where such information

is not. Chae (2005) argues that the availability of the timing information about

corporate announcements gives rise to distinct trading patterns by liquidity traders. More

specifically, when timing information is available in advance, discretionary liquidity

traders in the sense of Admati and Pfleiderer (1988) know that a large amount of

information will be released on a known date. Since they do not know whether the

information will be positive or negative, they might respond by changing the timing of

their trades. For example, they might postpone their trades until after the announcements

if they anticipate adverse price movements associated with the information release. In

contrast, when timing information is not available prior to the actual announcements,

liquidity traders have no bases to time their trades and trade just as usual. Consistent

with this argument, Chae (2005) finds and we are able to confirm that abnormal trading

volume increases before unscheduled announcements and decreases before scheduled

announcements.

This paper takes the analysis in Chae (2005) one step further by examining insider

trades before scheduled versus unscheduled announcements. We aim at investigating

whether or not insiders indeed respond to the time variation in liquidity trading before

different announcements. This question is critically important to the strategic trading

literature. Models of strategic trading predict that informed traders will try to hide their

trades among liquidity trading so as to prevent their private information from being

revealed fully and instantaneously.2To the extent that the amount of liquidity trading is

time-varying around scheduled versus unscheduled announcements, the varying trading

patterns imply different levels of camouflage for insider trades. Consequently, the

decisions of whether and how insiders trade before announcements can be influenced

by the time-varying liquidity trading before such announcements, and this paper carries

out the tests to see if the data support these predictions.

Following Chae (2005), we treat quar terly earnings announcements as scheduled

announcements while the announcements of mergers and acquisitions are considered as

unscheduled announcements. Chae (2005) chooses these two types of announcements

1Given their unique informational advantages, corporate insiders are quite natural proxies

for informed traders. The presence of ample corporate events makes this approximation even

more appealing when we examine insider trades under asymmetric information.

2An incomplete list of strategic trading literature includes Kyle (1985, 1989), Admati and

Pleiderer (1988), Holden and Subramanyam (1992), Foster and Viswanathan (1994, 1996),

and Huddart et al. (2001).

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