Monday, January 4, 2016

Insider Trading on Information with No Expected Return?

Assume you acquire some nonpublic information about a company that will have no predictable effect on the company’s stock price, but will affect the volatility of that stock price. Is that information material nonpublic information for purposes of the prohibition on insider trading?

That’s one of the issues addressed in an interesting article written by Lars Klöhn, a professor at Ludwig-Maximillian University in Munich, Germany. The article, Inside Information without an Incentive to Trade?, is available here. His answer (under European law)? It depends.

Here’s the scenario: one company is going to make a bid to acquire another company. The evidence shows that, on average, the shareholders of bidders earn no abnormal returns when the bid is announced. There’s a significant variation in returns across bids: some companies earn positive abnormal returns and some companies earn negative abnormal returns. But the average is zero. Of course, the identity of the target might affect the expected return, but to pose the problem in its most complex form, let’s assume that you don’t know the target, just that the bidder is planning to make a bid for some other company.

In that situation, the stock is just as likely to go down as to go up if you buy it. Because of that, Professor Klöhn argues that the information should not be considered material to anyone buying or selling the stock.

However, the information about the bid will make the bidder’s stock price more volatile. The average expected gain is zero, but either large gains or large losses are possible, increasing the risk of the stock. Professor Klöhn argues that, since this risk can be diversified away, it should not affect the bidder’s stock price. However, the increased volatility would allow a trader to profit trading in derivatives based on the bidder’s stock. In other words, the information should affect the value of derivatives. Therefore, the information should be considered material in that context, and anyone using the nonpublic information to trade in derivatives should fall within the prohibition on insider trading.

It’s an interesting article, not very long and definitely worth reading. Professor Klöhn’s focus is on European securities law, but American readers should have no trouble following the discussion.

C. Steven Bradford, Comparative Law, Securities Regulation | Permalink


I can’t see how it’s NOT material as a matter of law under the standard articulation. The decision to buy or sell depends on whether your own valuation of the company’s prospects make the current market price of the stock (not a derivative) cheap or expensive. The most sophisticated valuation methodology is discounted cash flow, with the discount rate being the firm’s weighted average cost of capital. The cost of equity depends on the calculation of the variance from the risk-free rate, which in part turns on the beta factor that measures market volatility of the stock. If the information would cause the stock to be more volatile, it will increase the beta and thus the WACC and thus depress the present value of future cash flows. In that circumstance, I’m a seller.

At the very worst, there’s a fact issue whether a substantial likelihood a reasonable investor would consider the volatility significant, given the total mix of information. Summary judgment denied.

Posted by: Jeff Lipshaw | Jan 4, 2016 9:04:44 AM


Making my assumption that we don't know anything about the target and accepting that bidders on average have zero gain or loss, the expected value of the returns hasn't changed at all. His argument is that this is diversifiable, firm-specific risk, not systematic risk, that shouldn't affect the stock price (as opposed to derivative prices).

Steve Bradford

Posted by: Steve Bradford | Jan 4, 2016 9:19:56 AM

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