Who Are They?

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Does Insider Trading RaiseStock Market Volatility?(Economic Journal, Oct 2004)

Julan DuChinese U of HK

and

Shang-Jin WeiIMF and NBER

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

-20

-10

0

10

20

30

40

50

Feb-9

2

Jun-

92

Oct

-92

Feb-9

3

Jun-

93

Oct

-93

Feb-9

4

Jun-

94

Oct

-94

Feb-9

5

Jun-

95

Oct

-95

Feb-9

6

Jun-

96

Oct

-96

Feb-9

7

Jun-

97

Oct

-97

Feb-9

8

Jun-

98

Oct

-98

Feb-9

9

Jun-

99

Oct

-99

Feb-0

0

Jun-

00

Oct

-00

month

retu

rn(%

)

rHSI

rSHA

rS&P

Market Volatility

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

Stock Market Volatility

0

0.05

0.1

0.15

0.2

0.25

0.3

U.S. Hong

Kong

China Russia

U.S.

Hong Kong

China

Russia

Is volatility good or bad?

signal

What Explains the Cross-Country Dispersion?

Fundamentals output, cash flow, leverage, concentration

Macro Policies monetary, exchange rate & Fiscal policies

LiquidityMaturityIntegrity

Insider trading, Disclosure/accounting

Market Volatility vs. Output VolatilityV

olat

ility

of

Sto

ck M

arke

t R

etur

n in

US

$

Volatility of Real GDP Growth Rate0 .02 .04 .06 .08

0

.1

.2

.3

NLD

AUT

COL

ITADEUDNK

FRA

BEL

EGY

GRC

LKA

IDN

NOR

USA

CHEAUS

ESPSWEJPN

PRT

GBRCAN

IND

ISR

CHL

KOR

ZAF

NZL

PAK

LUX

CHN

IRL

HKGMYS

THA

NGA

SGP

PHL

FIN

SAU

MEX

TUR

HUNZWE

VEN

CZE

RUS

MAR

ARG

SVK

JOR

PER

Role of Fundamentals_____________________________________

V(GDP-growth)

1.15**(0.51)

1.70**(0.63)

1.72**(0.63)

Cash flow risk 0.028*(0.018)

0.025(0.018)

Leverageratio

0.020**(0.008)

0.019*(0.008)

Ent Billionairewealth/GDP

0.0001(0.0002)

Heir Billion.wealth/GDP

0.00003(0.00013)

#obs/ad.R2 54 / 0.17 39 / 0.46 39 / 0.45

Market volatility vs. Inflation volatilityV

olat

ility

of

Sto

ck M

arke

t R

etur

n in

US

$

Volatility of Inflation Rate (ARG & PER dropped)0 50 100

0

.1

.2

.3

NZL

TWN

SAU

SVK

AUT

BEL

USANLD

JPNFRA

DNK

SGPDEUMAR

CZEMYSZAF

EGY

CAN

ITA

THA

CHE

FINESP

LUX

KOR

GBR

NORIND

SWE

PRT

COLLKA

HUNGRCPHL

AUS

HKG

IRL

CHL

JOR

CHN

PAK

ZWE

IDN

TUR

NGAVEN

RUS

MEX

ISR

Market volatility vs. Interest rate volatilityV

olat

ility

of

Sto

ck M

arke

t R

etur

n in

US

$

Volatility of Real Interest Rate (ARG & PER dropped)0 .5 1

0

.1

.2

.3

SVK

NLD

DEUCHEAUTJPN

USA

FIN

MYS

LUX

NOR

NZL

ITA

GBR

SWE

CAN

SGP

THA

HKGCZE

DNK

KOR

ESP

BEL

IND

IRL

PRT

FRA

PAK

GRC

MAR

COL

AUS

ZAF

HUNPHL

EGY

ZWE

CHN

JOR

IDN

CHLLKA

TUR

VENNGA

MEX

RUS

ISR

TWN

Market Volatility vs. Fiscal Policy VolatilityV

olat

ility

of

Sto

ck M

arke

t R

etur

n in

US

$

Volatility of Fiscal Deficit/GDP0 2 4 6

0

.1

.2

.3

CHN

DEUCHEAUT

KOR

PAK

CAN

CZEINDCHL

USANLD

ARG

IDN

ESP

PHL

TUR

FRAAUS

ZWE

MAR

LKA

JPN

COL

BELDNK

HUN

ISR

ZAF

NGA

PER

GBRNZL

ITA

THA

VEN

PRT

NORMYS

IRL

RUS

EGY

LUXJOR

GRC

SWESGP FIN

MEX

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 MaturityV

olat

ility

of

Sto

ck M

arke

t R

etur

n in

US

$

Market Capitalization/GDP (LUX dropped)0 50 100 150

0

.1

.2

.3RUS

IDN

CHNTUR

HUN

ARG

MAR

COL

VEN

PER

NGA

EGY

PAK

GRC

LKA

AUT

MEX

SVKIND

ZWEPHL

ISR

THAPRT

NORCZE

IRLITADEUFRA

ESP

DNK

CHLFIN

NZL JORBELSAUNLDCAN

AUSSWE

USA

MYS

CHEGBR

SGP

HKG

JPN

ZAF

Market Volatility vs. GDP per capitaV

olat

ility

of

Sto

ck M

arke

t R

etur

n in

US

$

Log of Per Capita GDP6 8 10

0

.1

.2

.3

IND PAK LKA

CHN

IDN

EGY

PHL

NGA

ZWE

MAR

THA

COL

PER

TUR

JOR

MYS

CHLZAF

MEX

HUN

SVK

KOR

VEN

RUS

CZE

ARG

PRTGRC

TWN

ESPIRLISR

NZL

HKG

SGP

SAUGBR

ITAAUSAUT

BELNLD

FINFRA

CANDNKJPNSWE

USA

NOR

LUXCHE DEU

Market Integrity

Insider trading

Information Disclosure

Variations in Insider Trading Prohibition

Laws on the book

“Corporate Insiders”

“Constructive Insiders”

“Tipees”

“Mis-appropriators”

Enforcement of Existing Laws/Regulations

Penalties for Violations

Civil PenaltiesCriminal Penalties

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 volatilityReduce 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 1-7 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

Vol

atili

ty o

f S

tock

Mar

ket

Ret

urn

in U

S$

Insider Trading Index0 1 2 3

0

.1

.2

.3

DEUDNK

GBR

IRLSGP

NZLLUXSWE

CHEAUSFIN

USA

JPNCANBEL

AUTFRA

NOR

NLD

CHL

PRT

ESP

HKG

TUR

ISR

ARG

HUN

COL

ZWE

ITA

ZAF

EGY

PER

KORMYS

JOR

GRC

MEXTWN

IND

RUS

IDN

PHL

CHN

THA

SVK

VEN

CZE

Table 2: Insider Trading & Market Volatility

Dependent Variable: Volatility of Stock Returns (in US Dollars)Specification OLS OLS OLS OLS IV IVInsider Trading Index 0.035** 0.017* 0.015# 0.076** 0.052**

(0.006) (0.010) (0.010) (0.030) (0.023)

Volatility of Real 1.471** 1.163* 1.202** 0.488 0.715GDP Growth Rate (0.538) (0.579) (0.583) (0.601) (0.494)

Log Per Capita GDP -0.007 -0.007 0.021 0.011(0.007) (0.008) (0.015) (0.012)

Market Capitalization/GDP -0.005 0.001 -0.017(0.004) (0.098) (0.021)

R-squared 0.24 0.36 0.48 0.48 - -No. of Obs. 52 48 47 46 46 45

Table 4: Adding Volatility of Macro Policies (IV)Dependent Variable: Volatility of Stock Returns (in US Dollars)

Insider Trading Index 0.067** 0.063** 0.058** 0.058**(0.024) (0.027) (0.022) (0.024)

Volatility of Real 0.292 0.326 0.377 0.385GDP Growth Rate (0.657) (0.667) (0.619) (0.633)

Volatility of Inflation Rate 0.003** 0.005 0.003* 0.009(0.002) (0.054) (0.002) (0.052)

Volatility of Fiscal Def./GDP 0.001 0.001 0.001 0.001(0.005) (0.005) (0.005) (0.005)

Log Per Capita GDP 0.016 0.015 0.014 0.013(0.012) (0.013) (0.011) (0.012)

Market Capitalization/GDP 0.001 -0.011 -0.013 -0.012(0.009) (0.023) (0.022) (0.023)

No. of Obs. 44 41 43 41

An Example

US (1)

China (2)

Difference (3)=(2)-(1)

Increase in mkt Volatility

Insider Trading

2.62

4.62

2.00

245 bp

Output Volatility

1.7%

3.0%

1.3%

103 bp

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