Is Dividend Policy Related to Information Asymmetry: Evidence from Insider Trading Gains
46 Pages Posted: 15 Nov 2002
Date Written: November 2002
The existence and implications of asymmetric information in financial markets have been the subject of extensive research in the finance literature. Two of the major propositions in this literature are that (1) corporate insiders take advantage of asymmetric information by trading on their informational advantage and (2) dividend policy is related to asymmetric information. It follows there may be a relationship between dividend policy, asymmetric information, and insider trading gains. The purpose of this paper is to examine whether such a relationship exists. There are three theories about dividend policy that motivate this relationship. The first theory is the "free cash flow theory" of dividends, which focuses on the divergence of interests between managers and shareholders and on dividends as a disciplining mechanism that reduces the agency costs (see Easterbrook (1984), Jensen (1986)). The second is the "institutional monitoring theory" based on Allen, Bernardo, and Welch (2000), which focuses on the role of institutions as a monitoring mechanism. The third theory is the "information signaling theory" of dividends, which argues that dividend changes reduce asymmetric information by acting as a signaling mechanism (See Bhattacharya (1979), Miller and Rock (1985), John and Williams (1985), John and Lang (1991)). This paper uses insider trading gains as a proxy for information asymmetry, as well as a variable of interest in its own right, and finds a cross-sectional relationship between dividend policy and asymmetric information/insider trading gains. Using a sample of insider trades from 1982 through 1995, we find that dividend policy is a determinant of insider gains/information asymmetry. First, we find that the higher a firm's dividends, the lower its insider trading gains. Second, we find that whether or not a firm pays dividends is not a determinant of insider gains. Third, we find little evidence that changes in dividend policy affect information asymmetry. Thus, we find the evidence is most consistent with the "free cash flow theory."
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