New Developments in Long-Term Asset Management
May 19-20, 2017
Chasing Private Information
Information asymmetries are ubiquitous in financial markets. Some investors may learn before others about the outcome of a particular corporate decision. Academics argue that the presence of such better-informed market participants can affect asset prices, firms' cost of capital, and corporate governance. Empirical research aims to test for the presence of such informed investors. Asset managers want to detect the presence of informed investors, as they do not wish to buy or sell at times when other traders know more than they do.
Other Conference Papers
Institutional Investors and Information Acquisition, Matthijs Breugem and Adrian Buss
A major issue for both academics and practitioners is inability to observe investors' information sets. Given this limitation, a second-best alternative in test design is to rely on specific pieces of public information that may signal the presence of informed investors. Trade theories are helpful in this regard as they point to three groups of useful "private information signals": trade volume, price volatility, and asset illiquidity. In general, economists believe that these metrics should be higher when informed investors are present, but, without direct evidence on how reliable such signals actually are, it is difficult to make progress in the empirical analysis of asymmetric information.
In addition to studying stock markets, the research also allows for an evaluation of the impact of private information on option markets. Despite the intuitive appeal of options for informed traders, options receive considerably less research attention than stocks. Because the research sample includes individuals with small capital, wealthy individual investors, and institutional investors such as hedge funds, it also allows study of traders with different skills. The final sample contains 5,058 trades in 615 firms over the period 1995-2015. On days when insiders trade, their trades constitute more than 10 percent of the total volume for stocks and more than 30 percent for options. On average, informed investors realize about 40 percent returns over a holding period of a few weeks.
Kacperczyk and Pagnotta's basic test is intuitive: If information signals help detect privately informed traders, they should display abnormal behavior on days when informed traders trade. They report three key results. First, trades based on private information about firms' fundamentals display abnormal behavior. Second, options markets reveal strong informational content. On days when informed traders trade, the volume in options markets as a fraction of that in the stock of the same company is disproportionally higher. The difference is economically meaningful: the ratio of options to stock volume is more than 60 percent higher on days with informed trades.