Insider Holdings and Perceptions of Information Asymmetry: A Note

RESEARCHERS HAVE FOUND THAT trades by corporate insiders yield excess profits (for example, Finnerty [9] and Jaffe [11]). In an efficient capital market, we should expect other market participants to consider this in their investment/ trading decisions. Demsetz [7] notes that, to protect themselves, ordinary (uninformed) investors may adopt a buy-and-hold strategy but incur the "cost of illiquidity" in doing so. Therefore, he argues, the recorded rates of return (measured before losses to insiders) should be higher for stocks more likely to present outsiders with informationally disadvantageous trades. Based on a 159firm sample, he finds that there is a significant positive correlation between the recorded market rates of return and the ratio of insider trading to total trading. In this paper, we study the market's perception of information asymmetry between insiders and outsiders through the behavior of another group of tradersthe dealers/specialists. The degree of information asymmetry is proxied here by the concentration of insider holdings. The dealer/specialist provides the trading public the service of immediacy by standing ready to buy and sell. He or she incurs, in the process, inventory holding costs and information trading costs, which are the expected losses due to transactions with informed traders. Therefore, the dealer/specialist sets the bidask spread (his or her source of revenue) according to the anticipated levels of these costs. In particular, it has been shown that the higher the information trading cost, the wider the spread should be (Jaffe and Winkler [12], Copeland and Galai [6], and Glosten and Milgrom [10]). Thus, ceteris paribus, a higher degree of information asymmetry leads to a larger bid-ask spread. The question, then, is what factors influence the dealer's assessment of information asymmetry. One convenient measure is the extent of insider holdings. Corporate insiders have access to nonpublic firm-specific information and exercise a good deal of corporate control. We use the percentage of ownership by corporate insiders as a proxy for the degree of information asymmetry faced by the dealer. A positive correlation between spreads (net of holding costs and firm-size effects) and insider holdings would imply that dealers perceive a positive relationship between insider holdings and information asymmetry. We also study how the market views institutional holdings through the effect on bid-ask spread. Compared with the typical stockholder, institutions tend to hold larger blocks of a firm's stock; thus, their information acquisition costs are spread over a larger investment, creating an incentive to acquire information.