An investigation of insider trading profits in the Spanish stock market

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Abstract

This paper investigates the profitability and information content of insider trading in the Spanish stock market. Our results show that insiders earn excess profits when investing on corporate nonpublic information, while outsiders mimicking them fail to obtain those excess returns. The paper also investigates the relevance of a third party investing on the insider’s behalf. The study further focuses on some methodological aspects, such as the need to take estimation periods that are not affected by other events or by other prediction periods, and the need to allow volatility during insider trading events to have interday memory.

Introduction

Insider trading literature focuses on the examination of insiders trading on material, nonpublic corporate information, so as to gauge whether insiders earn larger profits than those they would obtain if they traded on the available public-information set. The rationale of this research lies in the debate over whether insider transactions produce more informative security prices, fostering market efficiency, or whether these large profits point on the contrary to the inefficiency of capital markets. Furthermore, research on insider trading also attempts to ascertain the extent to which noninsiders could achieve the excess returns earned by insiders. Previous papers have produced contradictory evidence regarding the profitability of insiders and the social effects of insider trading. Kerr 1980, Lin and Howe 1990 and Holderness and Sheehan (1985) support strong-form efficiency, while Jaffe 1974a, Seyhun 1986, Seyhun 1988a or Madura and Wiant (1995) identify abnormal performance attributable to insiders; some of the latter papers also produce evidence against the semistrong form of the efficient market hypothesis (hereafter EMH). However, the literature on insider trading mainly supports the view that while insiders manage to outperform the market, outsiders cannot obtain excess returns by merely imitating insiders’ transactions.

The research on insider trading has been confined to a small number of financial markets. In addition to U.S. markets, studies on insider trading have been performed for the Canadian and Mexican stock markets (Baesel and Stein, 1989 and Bhattacharya et al. 2000, respectively) and, in Europe, only for the Oslo Stock Exchange (Eckbo and Smith, 1998) and the London Stock Exchange (Pope et al., 1990). Our research uses Spanish stock market data for the first time to examine the debate on the profitability and information content of insider trading and its benefits and drawbacks.

Insider trading is illegal in Spain. Under the assumption that the drawbacks of insider trading outweigh its benefits, both company and security market laws are designed to prosecute and penalize the use of private information by corporate insiders. Though more recent and less developed than U.S. rules, the comprehensive Spanish legislation on insider trading does promulgate the disclose-or-refrain rule. It is telling, however, that there is, no record of insider trading having been prosecuted in recent decades. That may cast doubts on the effectiveness of these laws, raising the question of whether insiders may be encouraged to invest on the basis of their private information.

There is little literature on the use of private information in Spanish stock markets. As a result, it is quite difficult to anticipate how insider trading may be affecting market efficiency.1 Spanish markets are in need of a comprehensive research on the investment behavior of informed traders. With regard to the market microstructure literature, only a few papers such as Tapia (1996) and Rubio and Tapia (1996), analyze trading behavior in an asymmetric-information setting, suggesting that informed investors usually benefit from their trading. In the context of the event study methodology, Ocan̄a et al. (1997) and Del Brio et al. (2000) also suggest that insiders may be exploiting their private information. Taking a sample of take-overs and investment announcements, respectively, both detect that the market reacts during the preannouncement period, which may be attributable to the presence of private information in the market. However, in neither case are data on insider trades used. Another relevant but unexplored aspect of insider trading in Spanish markets is the debate on the desirability of the legalization of insider trading. As far as we know, only the legal literature on insider trading has focused on this issue.

From the foregoing it may be readily concluded that this paper has a big gap to fill. Firstly, it should yield conclusions as to the profitability and information content of insider trading in the Spanish market, since this has never been done before. Secondly, in view of the results, and bearing in mind that insider trading is prohibited under Spanish laws, the paper should determine whether insider trading effects on the formation of security prices are beneficial or harmful, and evaluate the effectiveness of insider trading laws.

However, the scope of the current study goes beyond this debate. Some of the papers that provide evidence on the abnormal performance of inside traders commonly document the presence of model misspecification and other features that might be distorting their results. This paper investigates whether the results remain the same after controlling for some of these deficiencies. The paper thus gauges the sensitivity of the results to some improvements in the methodology: the use of daily data,2 the selection of estimation periods that are not contaminated by other events or other prediction periods, the use of ARCH models to capture the stochastic behavior of financial asset prices, and the elimination of the intensive-trading criterion to select the insiders’ transactions based on private information.3 It is also documented how these methodological issues may contribute to increasing the robustness of results and conclusions. Furthermore, the paper analyses whether the measure of abnormal returns is sensitive to changes in the return-generating model.

In this paper, we show that Spanish insiders do benefit in their open-market transactions, as evidenced by the large excess returns detected on insider trading days. Profits thereafter turn significantly negative or disappear as more investors gain access to private information and its value decreases. This pattern reveals that uninformed investors do not succeed when imitating insider investment rules. Insider traders therefore manage to beat the market by timing their purchases and sales while outsiders mimicking them fail to obtain positive excess returns. The primary implications of these results are twofold: firstly, our results support the semistrong form of the EMH and provide evidence against its strong form. These results may thus shed new light on the discussion concerning the desirability of insider trading. The second implication of the study is methodological. Our results against strong-form efficiency are achieved after controlling for some of the methodological deficiencies that have traditionally been blamed for the failure to accept the EMH.

Other findings of the study could also be highlighted. One significant contribution of the paper is the distinction drawn between direct versus indirect insider transactions. We incorporate a new variable into the empirical research on insider trading: the transparency of the insider transaction. Our results show that insiders camouflage their trading by delegating it to a third person. In those cases, abnormal returns are not detected on the transaction date, but later on. Finally, when the sample is partitioned into sales and purchases, the results reveal that sales are more information-induced than purchases, since cumulative returns associated with sales are significant for the holding period.

The remainder of the paper is as follows. A brief overview of previous research is summarized in the next section. 3 Sample description, 4 Methodology respectively describe the characteristics of the sample and methodology utilized. Section 5 presents and interprets the empirical results and the conclusions. Implications of the study are drawn in the final section, section 6.

Section snippets

Previous empirical evidence

The empirical research on insider trading has traditionally been broad in scope. Apart from its original goal, that is, the measurement of abnormal returns made during periods of heavy insider trading, researchers have analyzed insider-trading patterns in various settings: (i) a comprehensive study of both legal and illegal insider transactions around some firm-related events, such as take-overs Seyhun 1990, Eysell and Arshadi 1993, CEO turnover (Niehaus and Roth, 1999), equity issues Gombola

Sample description

Our sample consists of daily insider trading data collected from the Daily Historical Records of Insiders Transactions, compiled for this study by the Department of Studies of the Comision Nacional del Mercado de Valores (CNMV), which is the Spanish version of the SEC (Securities and Exchange Commission). Like the SEC, the CNMV requires officers, directors, and large shareholders5 of all publicly held firms to report all their transactions in their firms’ stocks. Unlike the SEC, the CNMV

Measuring abnormal returns

To determine whether insiders, and outsiders mimicking them, are able to earn abnormal returns, we applied the methodology of event studies. Hence, we tested whether abnormal returns on an insider trading day (or Day 0) and the surrounding period are significantly different from zero. To measure abnormal returns, prediction errors were calculated by subtracting expected or “normal” returns from current returns. Current returns are constructed as the logarithmic conversions of returns adjusted

Results on the profitability and information content of insider trading in the Spanish market

This paper offers evidence that is inconsistent with strong form efficiency, which states that all information, public or private, is fully reflected in stock prices. This result is demonstrated by the average abnormal returns (ARs) plotted in Fig. 1, and the t-values (t_MM, W_MM and W_CARCH) displayed in Table 1, which indicate that ARs on Day 0 are significantly different from zero, at the 1 and 5% levels. It is clear that abnormal returns are detected when insiders trade (on Day 0). Insiders

Conclusions and implications of the study

The rationale of this study consists in analyzing both the profitability and the information content of insider trading in Spanish stock markets. Our results suggest that the strong form of the EMH does not hold, since insiders earn returns that exceed risk-adjusted benchmarks. In fact, the picture emerging is a semistrong efficient market, where insiders are able to beat the market by investing using their private information on a firm’s prospects, while outsiders cannot earn abnormal profits

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