Evidence on the Non-Linear Relation between Insider Trading Decisions and Future Earnings Information
Journal of Law, Economics, and Policy, Vol. 4, No. 2, pp. 409-448, Spring 2008
Posted: 29 Sep 2008 Last revised: 8 Oct 2013
Date Written: September 25, 2008
In this paper, we explore an insiders' decision to trade or not trade on the basis of future earnings information. Consistent with litigation, political, and reputation-related costs shaping insider-trading decisions, we find that relations between insider trading decisions and next year's earnings change are not strictly linear. First, we find that the likelihood of insider purchases is positively related to next year's earnings innovation, yet this relation is attenuated in the case of extreme positive innovations. Second, we find that the likelihood of an insider selling shares and exercising stock options is negatively related to next year's earnings innovation, yet this relation is attenuated in the case of extreme negative innovations. The non-linear relation between insider sales and future negative earnings news is more pronounced than the nonlinearity between insider purchases and future earnings news, suggesting that the expected costs associated with insider selling are economically larger than the costs associated with insider buying. Together, these estimations suggest that insiders trade on the basis of future earnings news, yet there exist regions where the expected costs of trading subsume the expected gains to trading on private information. Finally, we investigate the role of earnings persistence as an alternative explanation for our results. We find that insiders only trade on persistent earnings innovations, and that, after controlling for persistence, insiders still curtail trading when earnings innovations are extreme.
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