Abnormal Gains For Insiders Trading Prior To Unexpected Corporate Earnings And Dividend Announcements
According to the strong form of the efficient market hypothesis, at any time all relevant information, whether public or private, is already reflected in stock prices. If this view were true, then no investors, even those who have private inside information about a company, can consistently earn rates of return above those that could be earned by selecting stocks randomly. One test of this hypothesis is to examine the trading activities of corporate officials, who are presumed to be acting on the basis of their inside information, prior to major announcements about their companies. If insiders can be shown to earn risk-adjusted excess returns, then the strong form efficient market hypothesis cannot be accepted. On the other hand, if the tests suggest that corporate officials are unable to out-perform the market, then stock market prices would reflect the set of all possible information about a company's stock. This study examines opportunities for abnormal gains by corporate insiders trading prior to their respective companies' announcements of earnings and/or dividends, measured within the context of the Capital Asset Pricing Model (CAPM).
The Securities and Exchange Commission (SEC) is charged with the responsibility of ensuring orderly and efficient stock markets. It is recognized by many that rules governing insider trading are difficult to enforce[9, 24]. Although insiders are required to file a record of their transactions with the SEC, it is believed that some transactions go unreported. Clearly, unreported transactions are illegal. However, some previous studies, using reported data, suggest that insiders, on average, are still able to outperform the market.
For example, Penman found that over the period from 1967 to 1974, corporate officials were able to earn risk-adjusted excess returns by trading before public announcements of company forecasts of earnings. Keown and Pinkerton
suggested that insiders earned abnormal returns prior to merger announcements. Givoly and Palmon examined insider trading to determine if abnormal returns were realized from the disclosure of eleven classes of events. They found significant abnormal returns during the 1973-1976 test period. The research presented here supplements previous studies in that methodological improvements are made, a more powerful statistical technique is used that provides more information, and a more recent time period, i.e., 1982-1983, is examined.
More specifically, the purpose of this study is to ascertain if corporate insiders, who are assumed to be trading on the basis of inside information, are able to profit enough from their transactions so as to outperform the stock market by buying their company's stock prior to favorable earnings and dividend announcements of their firm. Similarly, insiders are expected to avoid losses by selling their company's stock prior to unfavorable earnings and dividend news.
THE INFORMATION CONTENT OF EARNINGS AND DIVIDEND ANNOUNCEMENTS
The risk-adjusted excess returns that are earned by insiders are derived from their foreknowledge of corporate developments and from the probable effect of the announcement of those developments on the company's share prices. The majority of studies that examined the information content of earnings and dividends announcements mostly support the contention that information is conveyed to the market. Therefore, what is known is that these announcements contain information relevant to a firm's valuation. However, what is not known is whether insiders are able to profit from the price adjustment that takes place when the new information is announced. That question is examined in this study.
Distinctions in Methodologies Among Studies
A number of previous studies have dealt with insider trading. Among the earlier research, Pratt and DeVere failed to make adjustments for risk. …