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FINC3014 Topic 9:

Efficient Markets Hypothesis & Insider


Trading

Market Efficiency & Insider Trading Solutions

Question 1

What is the joint hypothesis problem as it relates to tests of capital market


efficiency? Carefully explain why a better asset pricing model will not solve this
potential problem.
The joint hypothesis problem occurs because any test of market efficiency is by
definition a test of both market efficiency and an asset pricing model. That is, to
determine if returns are inappropriately large or small requires a model of what is
appropriate or fair. A better asset pricing model cannot resolve this problem
because it only redefines the notion of what is a fair return. A return that deviates
from the fair return may be due to an inappropriate model or due to a market
inefficiency.

Question 2

Advocates of behavioural finance argue that the stock market sometimes


overreacts and sometimes under-reacts. What is the basis for this argument, and
how do believers in market efficiency counter the argument?
When stocks are grouped into winners and losers based on the most recent 5
years of returns, it appears that the loser stocks perform better over the next 5
years than the winner stocks do. In other words, the performance of the two
groups reverses. This suggests that the market was too optimistic about the
winners and too pessimistic about the losers. In other words, the market
overreacted by bidding up winner stocks too high and bidding down loser stocks
too low.
In contrast, when winners and losers are sorted based on very recent (6-12
months) performance, the winners continue to be winners and the losers continue
to be losers over the next 6-12 months. This suggests that the market under-
reacted, that is, the market did not fully incorporate just how well the winner
stocks would perform and just how badly the loser stocks would perform.
EMH believers say that this mixed pattern of apparent over and under-reaction is
what we expect in an efficient market. Only if stocks systematically overreact or
under-react would we conclude that markets are inefficient. If it appears that
markets sometimes overreact and sometimes under-react, that is analogous to a
mutual fund manager who sometimes beats the market and sometimes trails the
market.
Question 3

Suppose that we wished to conduct an event study on whether acquiring firms


experience share price reactions to takeover announcements. For our event
study, we will use for our sample the following three acquiring firms:
Company X: Merger announcement date January 15 2016
Company Y: Merger announcement date February 15 2016
Company Z: Merger announcement date April 10 2016
Suppose we establish an 11-day testing period for returns around the event
dates, the event date plus five days before and five days after. The table on the
right provides our three acquiring firm stock prices during 12-day periods around
merger announcement dates.

a) Compute one-day returns for each of 11 days for each of the three stocks.
Acquiring company daily stock returns, (Pt/Pt-1) 1, are computed as
follows:

(a)
Prices Returns

Day X Y Z X Y Z
-6 50.125 20 60.375
-5 50.125 20 60.5 0.000% 0.000% 0.207%
-4 50.25 20.125 60.25 0.249% 0.625% -0.413%
-3 50.25 20.25 60.125 0.000% 0.621% -0.207%
-2 50.375 20.375 60 0.249% 0.617% -0.208%
-1 50.25 20.375 60.125 -0.248% 0.000% 0.208%
0 52.25 21.375 60.625 3.980% 4.908% 0.832%
1 52.375 21.25 60.75 0.239% -0.585% 0.206%
2 52.25 21.375 60.75 -0.239% 0.588% 0.000%
3 52.375 21.5 60.875 0.239% 0.585% 0.206%
4 52.5 21.375 60.875 0.239% -0.581% 0.000%
5 52.375 21.5 60.875 -0.238% 0.585% 0.000%

b) Suppose that we have decided to use the mean adjusted return method to
compute excess or abnormal stock returns. Here, we will compute mean daily
returns for each security for a period outside our 11-day testing period.
Suppose we compute average daily returns and standard deviations for each
of the stocks for 180-day periods prior to the testing periods (the raw returns
data are not given here). Suppose that we have found normal or expected
daily returns along with standard deviations as follows:
Compute excess returns for each stock for each of the 11 days.
c) For each of the 11 days in the analysis, compute average residuals for the
three stocks. Then for each day, compute a standard deviation of residuals
for the three stocks. Finally, compute normal deviates for each of the 11
dates based on the averages and standard deviations for the three stocks.

(b) (c)
Excess returns (residuals)
Normal
Day X Y Z Average Std Dev Deviate
-6
-5 -0.047% -0.052% 0.199% 0.033% 0.143% 0.23
-4 0.203% 0.573% -0.421% 0.118% 0.503% 0.24
-3 -0.047% 0.569% -0.216% 0.102% 0.413% 0.25
-2 0.202% 0.565% -0.216% 0.184% 0.391% 0.47
-1 -0.295% -0.052% 0.200% -0.049% 0.247% -0.20
0 3.934% 4.856% 0.823% 3.204% 2.113% 1.52
1 0.193% -0.637% 0.198% -0.082% 0.480% -0.17
2 -0.285% 0.536% -0.008% 0.081% 0.418% 0.19
3 0.193% 0.533% 0.198% 0.308% 0.195% 1.58
4 0.192% -0.633% -0.008% -0.150% 0.431% -0.35
5 -0.285% 0.533% -0.008% 0.080% 0.416% 0.19
d) Are the average residuals for any of the dates statistically significant at the
95% level?
We shall assume that the residuals follow a t-distribution and we will perform
a one-tail test with a 95% level of significance. Given 1 = 3-2 degrees of
freedom, the critical value for each test will be t0.95,1 = 6.314. Based on the
computations in c) above, we find that none of the residual t-statistics
(normal deviates) exceed 6.314. Thus, we do not reject the null hypothesis
and we may not conclude at the 95% level of confidence that any residual
differs from zero.

e) Compute cumulative average residuals for each of the 11 dates.


f) Compute standard deviations and normal deviates for each of the 11 dates.

(e) (f)
Cumulative residuals
Cumul. Cumul. Cumul. Cumul. Avg Normal
Day Residual X Residual Y Residual Z Residual Std Dev Deviate
-6
-5 -0.05% -0.05% 0.20% 0.03% 0.143% 0.23
-4 0.16% 0.52% -0.22% 0.15% 0.372% 0.41
-3 0.11% 1.09% -0.44% 0.25% 0.774% 0.33
-2 0.31% 1.66% -0.65% 0.44% 1.160% 0.38
-1 0.02% 1.60% -0.45% 0.39% 1.078% 0.36
0 3.95% 6.46% 0.37% 3.59% 3.061% 1.17
1 4.14% 5.82% 0.57% 3.51% 2.684% 1.31
2 3.86% 6.36% 0.56% 3.59% 2.909% 1.23
3 4.05% 6.89% 0.76% 3.90% 3.070% 1.27
4 4.24% 6.26% 0.75% 3.75% 2.788% 1.35
5 3.96% 6.79% 0.74% 3.83% 3.028% 1.27

g) Does there appear to be statistically significant evidence of abnormal


acquiring firm returns around announcement dates?
Normal deviates do not exceed the critical value of 6.314. Therefore there
does not appear to be statistical evidence at the 95% confidence level of
abnormal returns around announcement date.
Question 4

Some lawyers and economists have argued that legalising insider trading would
benefit the market by allowing insiders to disseminate information through their
own trading activity. Prepare an argument to support this proposition.
While even insiders do not have perfect information concerning the stock
valuation of their companies, their information is likely to be superior to that of
the general public. If insiders are able to buy and sell shares on the basis of their
inside information, they will convey this information to the general public through
their trading activity and resulting price changes. The general public will buy and
sell stock to reflect this information. Thus, share prices will more quickly and
accurately reflect the best and most recent information relevant to the pricing of
shares. Markets will more closely resemble the theoretical strong-form efficient
market where prices fully reflect all information.

Question 5

What are other arguments (aside from that outlined in Q4) for legalising insider
trading?

Against insider trading regulation:

Insider trading leads to more informative prices and therefore more efficient
markets. An efficient stock market promotes the efficient allocation of capital
in that economy. Furthermore, utilitarian traders benefit, in a general sense,
from having more efficient prices
Insider trading serves as a form of managerial compensation. By allowing
managers to insider trade the company does not need to pay as large a
salary or offer EPS-diluting share / option placements. The compensation
shifts from the company to the market (see Manne, 1966, Insider Trading
and the Stock Market)
Managers are often forced to hold a disproportionate amount of their own
stock. Allowing insider trading serves as compensation for holding an
undiversified position.
In very large, complex, multi-divisional companies allowing insider trading
will result in the most reliable indicator of company health (i.e. in the stock
price). This can act as a useful input into the managerial decision making
process and could supplement non-price signals such as reports (see Manne,
2005, Insider trading: Hayek, virtual markets and the dog that did not bark,
Journal of Corporation Law, Fall 2005, 167:185).
Question 6

Read the article Insiders slip through legal net and answer the following
questions:
a) Why are insiders infrequently prosecuted?
Australian insider trading legislation requires that ASIC prove any criminal
cases beyond a reasonable doubt, which is a high standard of proof. They
need to prove not only that the individual had access to material, non-public
information but also that they traded on this information knowing that it
would cause a price reaction when released.
Prosecutions are also very costly, so ASIC will not initiate proceedings unless
it has a very high level of confidence that it can secure a conviction.
b) What other offences does the article say insiders are being charged with?
Insiders are being charged with easier to prove offences, such as fraud or
dishonestly using their position to gain an advantage.
c) Why is it necessary to prosecute insiders under different regulations?
Some of these offences are civil as opposed to criminal offences, meaning
that the required burden of proof is on the balance of probabilities rather
than beyond a reasonable doubt.
d) If price movements are observed prior to announcements, how efficient is the
Australian market?
If price movements are observed in the direction of the announcement, but
the information is not fully impounded, the market is somewhere between
semi-strong form and strong-form efficient.
Please refer to the following link about recent insider trading cases:
http://www.abc.net.au/news/2016-06-09/insider-trading-cases-tip-of-iceberg/7497236

Question 7
How might a clever insider arrange her trades to minimize the probability of
prosecution for insider trading while maximizing her gains from trading on inside
information?
Some arguments include buying a portfolio of stocks so as to avoid explaining to
regulators what could be a lucky trade. Also she could buy smaller amounts of
the stock so that she will avoid getting flagged by regulators as a suspicious
trade. She could possibly also let friends buy stocks on their account for her also,
however she will have to be cautious in this approach as some trading systems
have sophisticated trading programs that can link people together. She could also
buy small parcels of shares, options and futures to avoid making a big impact in
any one market. These trades could also be spread out, so that they were as far
away from the public release of the information as possible.
In a report to the Australian Government1, it was found that one of the major
obstacles to prosecution was the brokers relationship to their client. If the broker
has a good relationship with their client, then they are likely to warn their client
that they are going to be investigated in relation to insider trading. The broker
will know this information since the regulators need to request scrip ledger cards
(the history of dealings by the broker) before they interview the client. Thus the
client will have adequate time to make up an excuse.

1
1 http://www.aic.gov.au/publications/lcj/casino/ch10.html
Question 8

Consider the following scenario that takes place in the U.S.:
You enter a conference room for a meeting just as another group of employees
is leaving. One of the employees has left their papers on the table. You glance at
the materials and realize that they are confidential financial documents. They
show that our company will be posting excellent quarterly earnings at the end of
the month. A friend of yours has been considering buying stock in the company.
Should you tell your friend about the quarterly earnings? Before or after they are
publicly announced?
You should not share this confidential information with your friend until after it's
been publicly released. Even then, you should share no more information than
what is in the public domain. Sharing confidential financial information with a
friend prior to its being released publicly is not only unethical, it could lead to a
situation involving unlawful insider trading.
We have all watched high profile individuals facing criminal prosecutions for
insider trading. But what, exactly, is it and what do employees need to know to
avoid it?
The Securities and Exchange Commission ("SEC") is the federal government's
primary agency in charge of investigating and prosecuting insider trading cases.
Not all insider trading is unlawful. But, according to the SEC, unlawful insider
occurs when an individual buys or sells a security "in breach of a fiduciary duty or
other relationship of trust and confidence, while in possession of material, non-
public information about the security." Therefore, employees who act on
misappropriated confidential corporate information by buying or selling company
stock may be participating in unlawful insider trading.
What about the above scenario? According to the SEC and federal courts,
unlawful insider trading also includes "tipping" someone else, such as a spouse or
- in the example above - a friend, about the confidential information.

Question 9

Sellers of used cars and real estate certainly possess material non-public
information about what they sell. Why should insider trading be banned in
securities markets but not in real estate and other markets?
For insider trading regulation:
Regulating insider trading promotes fair markets, where no individual
receives an information advantage solely arising out of their employment
position. This promotes and creates a level playing field for all participants in
the market. If insider trading were allowed, it could deter short term traders
away from markets who have to factor in a higher adverse selection cost into
their trading. This might lower liquidity overall and impair market quality.
Fishe and Robe (2004) show that when insider trading occurs in markets
there is an increase in bid-ask spreads and a reduction in depth. Their result
however, is only apparent for NYSE traded stocks. Battacharya and Daouk
(2002) show that when insider trading laws are enforced in stock markets the
cost of capital in that economy is lowered.
Allowing insider trading provides managers with an incentive to maximize
their information advantage rather than to maximise shareholder wealth. This
means that managers might, theoretically, deliberately push a 12 company
into financial trouble in order to make a profit (via short selling), if this is
easier to do than making the company very profitable.
Allowing insider trading might also mean that managers withhold information
from the market (whether good or bad) in order to maximize their
information advantage thereby reducing the ability of shareholders to
monitor manager performance.
Why should insider trading be banned in securities markets but not in
real estate and other markets?
Insider information is often considered to be the property of the firms
owners. Trading on inside information can violate the insiders fiduciary
duties that the firms officers and directors owe to their shareholders. No
such fiduciary duties are violated in real-estate and other markets, nor is
there a violation of trust and confidence.
Inside traders in real-estate and other markets such as the labour market do
not obtain their inside information through illegal means or the breach of
professional ethics.
Because officers and directors control the production and disclosure of inside
information, they can use this information to transfer wealth from
shareholders to themselves. The sellers of real estate and other assets are
the beneficiaries of their own inside information.
The primary economic rationale advanced for prohibiting insider trading is
that such trading can adversely affect securities markets. Prohibiting insider
trading in labour and real estate markets would probably destroy those
markets.

Question 10

Some trading strategies are dependent upon particular market efficiency views.
What view of market efficiency is likely to be held by a:
a) Technical Trader
A technical trader is likely to believe that the market is not even weak form
efficient, as he/she believes that future stock price movements can be
predicted based on knowledge of past changes.
b) Value Trader
A value trader may or may not believe that the market is weak form efficient.
They will not, however, believe that the market is semi-strong form efficient
or above. If the market was semi-strong form efficient then their research
would be futile, all publically available information would already be priced
in.
c) Index Fund Investor
An index fund manager is likely to believe that the market is either semi-
strong form efficient, or even strong form efficient. To be more specific, they
are likely to believe that an investor is unable to earn excess risk-adjusted
returns after transaction costs are taken into account, and this is probably
going to manifest as a belief in semi-strong form efficiency.
d) CFO currently engaging in insider trading
A CFO engaged in insider trading is highly likely to believe that the market is
*not* strong form efficient. Insider trading would not be profitable in a
market that reflects all public and private information.

Question 11

Different asset classes have different levels of liquidity, differing barriers to entry,
differing transaction costs and differing levels of information disclosure.
How might different asset classes differ in their level of market efficiency?
Consider the Australian Equity market, FX market, as against secluded OTC
markets like those for various Fixed Income Derivatives.
The Australian market has differing levels of liquidity for different stocks. Blue
chip stocks experience a high volume of trading. Less liquid stocks may be less
efficiently priced due to the lack of an active market. Barriers to entry for
interested traders are very low, with individuals able to trade either through a
broker, or even CFD provider, at low cost. Information disclosure is mandatory,
through the ASX. As a result, market efficiency is likely to be high for the
Australian stock market.
The FX market is the worlds most liquid market. High volume currency pairs like
USDJPY, EURUSD, AUDUSD and so on experience multi-billion USD volumes.
Barriers to entry to the FX market are seemingly higher than the AU Equity
Market, as the FX market is OTC. In small quantities investors can access the
market through intermediaries. Transaction costs are exceedingly low for
institutional entities accessing the market in reasonable trading size. Most
information relevant to the FX market is publically available, with the market
mostly moved by macroeconomic data that is released in a coordinated manner
by government entities. As a result of these factors, global FX markets,
particularly for the most traded currency pairs, are likely to be exceedingly
efficient.
Some Fixed Income Derivatives markets experience lower liquidity levels than the
AU equity market. Although total notional traded may be exceedingly large, a few
dominant players control the market. Block trades may also account for most of
total traded volume. Barriers to entry are particularly high in some such markets,
with only a few investment banks, commercial banks, hedge funds or
supranational organisations actively participating in OTC and inter-broker
markets. Transaction costs may be quite high, due to the illiquidity. Whilst key
economic information is publically available, volume and price information can be
quite difficult to access for some market participants. Some examples of such
markets include the Cross Currency Basis market, FX Swap markets, Exotic
Interest Rate Swaps, Credit Default Swap markets and so on. Such markets may
be less efficient than the FX or Equity market. In fact, some assets listed on the
CDS market are functionally equivalent to assets listed on the Corporate Bond
market and yet, due to illiquidity, they trade with a basis, a difference in price.

Question 12

How might a high level of insider trading in a market affect market maker bid-ask
spreads and price/return volatility?
A high level of insider trading would be expected to increase adverse selection
costs for a market maker. Realized spreads may compress for the market maker.
In response to this a rational market maker would widen his/her quoted spread in
order to provide a buffer, protecting them against insider traders. Insider trading
may reduce the depth of the limit order book as investors try to avoid adverse
selection. This in turn may result in less resilience in the market, and the market
may fluctuate in a way that amplifies the normal fluctuation around fundamental
value.

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