Information, Trading and Product Market Interactions: Cross-Sectional Implications of Informed Trading

I present a simple model of informed trading in which asset values are derived from imperfectly competitive product markets and private information events occur at individual firms. The model predicts that informed traders may have incentives to make information-based trades in the stocks of competitors, especially when events occur at firms with large market shares. In the context of 759 earnings announcements, I use intraday transactions data to test the hypothesis that net order flow and returns in the stocks of non-announcing competitors have information content for announcing firms. ∗Yale School of Management, 135 Prospect Street, New Haven, CT 06520-8200. Phone: 203-436-0785; E-mail: [email protected]. This paper is based on part of my dissertation at Cornell University. I am grateful to Maureen O’Hara (Chair), David Easley, Robert Masson and Roni Michaely for many helpful discussions. I would also like to thank Warren Bailey, Carliss Baldwin, Scott Bauguess, Sudipto Bhattacharya, Joshua Coval, Judith Chevalier, John Griffin, Michael Hertzel, Kenneth Kavajecz, Norris Larrymore, Jonathan Macey, Adam Reed, Laura Starks, David Scharfstein, Matthew Spiegel, Robert Stambaugh (the editor), Bhaskaran Swaminathan, Eric Theissen, Nancy Wallace, James Weston, an anonymous referee, seminar participants at Cornell University, the 2003 European Finance Association Meetings, Arizona State, Yale SOM, U.C. Berkeley, Stanford, Harvard, UNC-Chapel Hill, the 2004 American Finance Association Meetings, the 2004 Batten Finance Conference, Yale Law School and MIT-Sloan for their useful suggestions. Any errors are my own. How does an informed trader’s propensity to trade on inside information in a given company’s stock vary with industry and firm characteristics? Using a simple model of informed trading in which asset values are derived from imperfectly competitive product markets and where private information events occur at firms, I examine the question of where informed traders choose to transact.1 This paper adds to existing research by explicitly linking informed trading in stock markets to the structure of competition in product markets. It also provides new evidence on the process of information diffusion across stocks as we vary the location at which private information is observed. Given privately observed information at a particular location (firm), informed traders may choose to trade in the stocks of related firms (in the same industry, for example). In addition to cross-stock trading incentives, this paper examines cross-sectional differences in where informed trading is likely to occur. I present a very simple model of informed trading in the context of both firm-specific and industrywide information events. I assume that asset values are derived from a Cournot duopoly with asymmetric constant marginal costs. Small, wealth-constrained informed traders decide whether to trade on privately observed information regarding a given firm’s future production costs in that firm’s stock or the stock of a competitor. I solve for the conditions under which competitor trading will occur.2 The model provides structure to the intuition of how information impacts more than one firm in an industry. We often start with returns as the basic element of financial models. What distinguishes the approach in this paper and in the literature on financial and product market interactions (e.g., Brander and Lewis (1986); Maksimovic and Titman (1991); Chevalier and Scharfstein (1996); Allen and Phillips (2000); Hou and Robinson (2006)) is that it takes one step back and explicitly accounts for the characteristics of firms and industries that generate returns. I begin with economic fundamentals to provide economic intuition as to what generates differences in stocks’ sensitivities to common information and how these sensitivities interact with insiders’ trading strategies. Beyond the implication that some insiders may choose to trade in the stocks of competing firms,