New Developments in Long-Term Asset Management

Supported by the Norwegian Finance Initiative
Monika Piazzesi and Luis Viceira, Organizers
Second Annual Conference
New York, New York

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

The Relevance of Broker Networks for Information Diffusion in the Stock Market, Marco Di Maggio, Francesco A. Franzoni, Amir Kermani, and Carlo Sommavilla

Asset Insulators, Gabriel Chodorow-Reich, Andra C. Ghent, and Valentin Haddad

Do Institutional Incentives Distort Asset Prices? Anton Lines

ETF Arbitrage under Liquidity Mismatch, Kevin Pan and Yao Zeng

Replicating Private Equity, Erik Stafford

Efficiently Inefficient Markets for Assets and Asset Management, Nicolae Gârleanu and Lasse Heje Pedersen

< 2016 Conference Papers>
< 2018 Conference Papers>

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.

Marcin Kacperczyk and Emiliano Pagnotta of Imperial College London address this challenge by focusing solely on trades that are unequivocally based on nonpublic information. These trades are identified in a hand-collected sample of insider trading cases prosecuted by the U.S. Securities and Exchange Commission (SEC). SEC documents detail how certain individuals trade on nonpublic and material information. Utilizing this data on insider trading, the researchers can observe the dynamics of any market signal when private information arrives. This is in contrast to prior work, which typically inferred the presence of informed trading either by observing the trading behavior of financial professionals, such as institutional investors, or trading behavior preceding important information events, such as earnings announcements.

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.

Finally, not all the signals move in the direction predicted by standard trade models. While volume and volatility are higher, measures of illiquidity display lower values. The latter include the quoted bid-ask spread, the order imbalance between buys and sells, and the standard illiquidity ratio.

The researchers suggest that the surprising relationship between informed trading and illiquidity measures is due to the use of limit orders by informed traders, as well as strategic timing of the trades. Informed traders seek to trade more when markets are more liquid for reasons other than their information.

The researchers also document more pronounced effects for unscheduled events, such as mergers, than for scheduled events, such as earnings announcements. For the latter, speculation by seemingly informed investors may interfere with the detection of actual information.

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