Asymmetric Effects of Informed Trading on the Cost of Equity Capital

Management Science, Forthcoming

59 Pages Posted: 12 Jan 2013 Last revised: 12 May 2015

See all articles by Michael J. Brennan

Michael J. Brennan

University of California, Los Angeles (UCLA) - Finance Area

Sahn-Wook Huh

State University of New York (SUNY) - Department of Finance

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Date Written: August 26, 2014

Abstract

We decompose the structural estimate of the probability of informed trading, PIN, into components that capture informed trading on good and on bad news. We estimate these two components at quarterly intervals, and provide new evidence that they capture informed trading around earnings announcements. Specifically, a high likelihood of trading on favorable (adverse) private information predicts positive (negative) earnings surprises. Motivated by arguments that investors may be more concerned about informed selling, which depresses the sale price of net long security holders, than about informed buying, which raises the sale price, we then investigate asymmetry in the pricing of private information as captured by the two different components of PIN. We find strong evidence of such asymmetry: the estimated effect of adverse private information on the equity cost of capital is large and highly significant, while the estimated effect of favorable private information is small and statistically insignificant.

Keywords: Information Asymmetry; Decomposition of PIN; Good-News PIN; Bad-News PIN; Earnings Announcements; Earnings Surprises; CAR; SUE; Cost of Equity Capital

JEL Classification: G12, M40, G32

Suggested Citation

Brennan, Michael John and Huh, Sahn-Wook and Subrahmanyam, Avanidhar, Asymmetric Effects of Informed Trading on the Cost of Equity Capital (August 26, 2014). Management Science, Forthcoming . Available at SSRN: https://ssrn.com/abstract=2199723 or http://dx.doi.org/10.2139/ssrn.2199723

Michael John Brennan

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825 3587 (Phone)
310-206 8419 (Fax)

Sahn-Wook Huh

State University of New York (SUNY) - Department of Finance ( email )

347 Jacobs Management Center
Buffalo, 14260-4000
United States
716-645-5435 (Phone)
716-645-3823 (Fax)

HOME PAGE: https://sites.google.com/site/sahnwookhuh/home

Avanidhar Subrahmanyam (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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