Who Are They?

Does Insider Trading Raise Stock Market Volatility?

(Economic Journal, Oct 2004)

Julan Du
Chinese U of HK
and

Shang-Jin Wei
IMF and NBER

return(%)

10

20

30

40

50

-20

-10

Monthly Returns for US, Hong Kong and China (1992-2000)

month

Fe b9 Ju 2 n9 O 2 ct -9 Fe 2 b9 Ju 3 n93 O ct -9 Fe 3 b9 Ju 4 n9 O 4 ct -9 Fe 4 b9 Ju 5 n9 O 5 ct -9 Fe 5 b9 Ju 6 n9 O 6 ct -9 Fe 6 b9 Ju 7 n9 O 7 ct -9 Fe 7 b9 Ju 8 n9 O 8 ct -9 Fe 8 b9 Ju 9 n9 O 9 ct -9 Fe 9 b0 Ju 0 n0 O 0 ct -0 0

rHSI

rS&P

rSHA

Market Volatility
standard deviation of monthly stock returns over 1985:1 - 1998:12

Stock Market Volatility

0.3 0.25 0.2 0.15 0.1 0.05 0 U.S. Hong Kong China Russia U.S. Hong Kong China Russia

Is volatility good or bad?

signal

What Explains the CrossCountry Dispersion?

Fundamentals
output, cash flow, leverage, concentration

Macro Policies
monetary, exchange rate & Fiscal policies

Liquidity Maturity Integrity

Insider trading, Disclosure/accounting

Market Volatility vs. Output Volatility

Volatility of Stock Market Return in US$
.3
RUS

ARG

.2
CHN NGA IDN THA MYS HKG MEX PHL HUN ZWE CZE SVK LUX IRL SGP FIN SAU MAR JOR TUR VEN

PER

.1

KOR PRT NOR IND ZAF LKA PAK COL CHL EGY ESP ITA AUS AUTFRA SWEISR JPN DEU CHE DNK CAN NZL BEL GBR NLD USA
GRC

0 0 .02 .04 .06 .08

Volatility of Real GDP Growth Rate

Role of Fundamentals _____________________________________

V(GDPgrowth) Cash flow risk Leverage ratio Ent Billionaire wealth/GDP Heir Billion. wealth/GDP #obs/ad.R2 54 / 0.17 1.15** (0.51) 1.70** (0.63) 0.028* (0.018) 0.020** (0.008) 0.0001 (0.0002) 39 / 0.46 1.72** (0.63) 0.025 (0.018) 0.019* (0.008)

0.00003 (0.00013) 39 / 0.45

Market volatility vs. Inflation volatility

Volatility of Stock Market Return in US$
.3
RUS

.2
CHN TUR NGA VEN MEX

IDN TWN HUN THA KOR PHL GRC PRT ZWE MYS CZE HKG IND NOR PAK ZAF LKA SVKCOLCHL EGY ESP FIN SGP ITA SWE IRL AUT AUS FRA JPN DEU LUX CHE DNK CAN JOR NZL BEL MAR SAU GBR NLD USA

.1

ISR

0 0 50 100

Volatility of Inflation Rate (ARG & PER dropped)

Market volatility vs. Interest rate volatility

Volatility of Stock Market Return in US$
.3
RUS

.2
CHN TUR NGA VEN MEX

IDN THAHUN KOR PHL GRC PRT ZWE MYS CZE IND HKG NOR ZAF PAK SVK COLCHL ESP EGY FIN SGP ITA SWE IRL AUT AUS FRA JPN DEU LUX CHE DNK CAN JOR NZL BEL MAR GBR NLD USA

TWN

.1

LKA ISR

0 0 .5 1

Volatility of Real Interest Rate (ARG & PER dropped)

Market Volatility vs. Fiscal Policy Volatility

Volatility of Stock Market Return in US$
.3
RUS

ARG

.2
CHN TUR

PER

NGA IDN

VEN

MEX HUN
THA PRT NOR EGY ITA NZL GBR IRL LUX JOR SGP FIN SWE GRC

KOR

PHL ZWE CZE IND CHL LKA COL ESP FRA AUS ZAF ISR

.1
AUT DEUCHE

MYS

PAK

CAN NLD USA

JPN BEL MAR DNK

0 0 2 4 6

Volatility of Fiscal Deficit/GDP

Adding Macro Policies

Inflation and exchange rate volatility add to stock market volatility Fiscal deficit does not matter for volatility Volatility of output growth and leverage ratio continue to add to market volatility Cash flow risk no longer significant

Market Liquidity and Market Maturity

Liquidity (ratio of market turnover to market capitalization) is insignificant. Three proxies for maturity: market cap/GDP, age of the exchange and GDP per capita A larger market cap/GDP or a higher GDP/capita is associated with a lower market volatility Mkt cap/GDP becomes insignificant once fundamentals/ macro policies are accounted for

Market Volatility vs. Market Maturity

Volatility of Stock Market Return in US$
.3
RUS

ARG

.2

PER TUR CHN NGA VEN IDN MEX HUN THA GRC PHL ZWE PRT IND NOR LKA CZE PAK COL SVK EGY ITA IRL AUT ISR MAR

.1

MYS HKG CHL ESP FIN FRA DEU DNK JOR NZL BEL SAU SWE AUS CAN NLD USA SGP CHE GBR JPN

ZAF

0 0 50 100 150

Market Capitalization/GDP (LUX dropped)

Market Volatility vs. GDP per capita

Volatility of Stock Market Return in US$
.3
RUS

ARG

.2
CHN NGA IDN

PER TUR VEN MEX PHL ZWE THA MYS ZAF CHL HUN GRC PRT CZE SVK TWN

KOR

.1

IND PAK LKA EGY MAR

HKG

NOR

COL

JOR

ESP FIN SGPITA AUT SWE IRLISR FRA AUS JPN LUX CHE DNK CAN NZL SAU BEL GBR NLD USA

DEU

0 6 8 10

Log of Per Capita GDP

Market Integrity

Insider trading Information Disclosure

Variations in Insider Trading Prohibition

Laws on the book
Corporate Insiders Constructive Insiders

Enforcement of Existing Laws/Regulations

Penalties for Violations

Tipees
Civil Penalties Criminal Penalties

Mis-appropriators

Insider Trading

on market volatility

Allows faster information realization Reduce noise in the price Reduce volatility

Improve efficiency

Insiders can benefit from volatility May choose riskier projects May manipulate the timing/content of information release Increase volatility Reduce efficiency

Previous empirical work

Legal trading by corporate insiders
-- only legal trades -- single country studies (US and UK)

Illegal inside trading as uncovered by the regulators

-- single country study (US) -- possible selection bias

Measuring Market Integrity

Insider trading
Laws on the book Actual Prosecution Survey of firm executives on the prevalence of insider trading (GCR) Extent of corruption (ICRG)

Information
Accounting Quality Disclosure

Insider Trading Index

Subjective index from GCR survey of firms in 53 countries. One of the questions (Q3.13) asked respondents to rate on a 17 how common insider trading is in the domestic stock market Average of all respondents for a given country is used as the value of the insider trading index for that country

Market Volatility vs. Insider Trading

Volatility of Stock Market Return in US$
.3
RUS

ARG

.2
TUR

PER CHN VEN

MEX IDN TWN PRT NOR CHL FIN SGP IRL SWE AUS DEU LUX CHE DNK NZL GBR JPN CAN BEL USA HKG ESP THA KOR GRC PHL MYS IND ZAF COL SVK EGY ISR ITA JOR HUN ZWE

.1

CZE

AUTFRA
NLD

0 0 1 2 3

Insider Trading Index

Table 2: Insider Trading & Market Volatility

Dependent Variable: Volatility of Stock Returns (in US Dollars) Specification OLS OLS OLS OLS Insider Trading Index 0.035** 0.017* 0.015# (0.006) (0.010) (0.010) Volatility of Real GDP Growth Rate Log Per Capita GDP 1.471** (0.538) 1.163* (0.579) -0.007 (0.007) 1.202** (0.583) -0.007 (0.008) -0.005 (0.004) 0.24 52 0.36 48 0.48 47 0.48 46 IV IV 0.076** 0.052** (0.030) (0.023) 0.488 (0.601) 0.021 (0.015) 0.001 (0.098) 46 0.715 (0.494) 0.011 (0.012) -0.017 (0.021) 45

Market Capitalization/GDP

R-squared No. of Obs.

Table 4: Adding Volatility of Macro Policies (IV) Dependent Variable: Volatility of Stock Returns (in US Dollars)
Insider Trading Index Volatility of Real GDP Growth Rate Volatility of Inflation Rate Volatility of Fiscal Def./GDP Log Per Capita GDP Market Capitalization/GDP No. of Obs. 0.067** (0.024) 0.292 (0.657) 0.003** (0.002) 0.001 (0.005) 0.016 (0.012) 0.001 (0.009) 44 0.063** (0.027) 0.326 (0.667) 0.005 (0.054) 0.001 (0.005) 0.015 (0.013) -0.011 (0.023) 41 0.058** (0.022) 0.377 (0.619) 0.003* (0.002) 0.001 (0.005) 0.014 (0.011) -0.013 (0.022) 43 0.058** (0.024) 0.385 (0.633) 0.009 (0.052) 0.001 (0.005) 0.013 (0.012) -0.012 (0.023) 41

An Example

US (1) Insider Trading Output Volatility 2.62 1.7%

China (2) 4.62 3.0%

Increase in Difference (3)=(2)-(1) mkt Volatility 245 bp 2.00 103 bp 1.3%

More volatility effect from an in insider trading

The volatility effect from an > in output volatility

To Conclude
Lack of market integrity contributes to market volatility The effect is quantitatively large relative to the effects of economic and policy fundamentals