Asymmetric Effects of Informed Trading on the Cost of Equity Capital

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