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Insider Trading in Hong Kong Some Stylized Facts

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					      Insider Trading in Hong Kong: Some Stylized Facts


                                    Man-Yin Cheuk

                                     Dennis K. Fan

                                    Raymond W. So



                                 Department of Finance
                            Chinese University of Hong Kong
                                Shatin, N.T., Hong Kong



                                       May, 2004




Address correspondence to Raymond W. Fan, Department of Finance, Chinese University of
Hong Kong, Shatin, N.T., Hong Kong, email: rayso@cuhk.edu.hk, tel: (852) 2609-7640, fax:
(852) 2603-6586.
                    Insider Trading in Hong Kong: Some Stylized Facts



                                         ABSTRACT

This paper examines the characteristics and price movements of legal insider transactions in
Hong Kong. Abnormal returns are analyzed for intensive trading, as well as for samples grouped
by industry classification, firm size, book-to-market ratio, price-earnings ratio, and relative
trading volume of the insider transactions. Results show that insiders are able to earn abnormal
profits from both buying and selling activities. The magnitude of and duration for abnormal
profits depend significantly on firm-specific and transaction-specific factors. We also document
the persistence of abnormal returns associated with insider sales, while abnormal profits
associated with insider purchases are concentrated in certain transactions.

Keywords: Insider Trading, Hong Kong, Information Asymmetry

JEL Classification: G14, G34
                     Insider Trading in Hong Kong: Some Stylized Facts



1. Introduction

       Many studies (e.g. Jaffe, 1974; Finnerty, 1976a and 1976b; Seyhun, 1986, 1988a, 1988b;

Rozeff and Zaman, 1988; Lin and Howe, 1990) conclude that insiders can earn abnormal profits

through trading stocks of their own firms. Apart from investigating the abnormal performance of

the stock price around insider transactions, research efforts also focus on whether outsiders are

able to earn abnormal profits by mimicking the trades of corporate insiders (e.g. Seyhun, 1986;

Rozeff and Zaman, 1988; and Chang and Suk, 1998). The conclusions on these issues, however,

are mixed.

       The main objectives of this paper are to document the characteristics of legal insider

transactions on the Hong Kong stock market, to examine the abnormal stock price movements

associated with insider trading, and to comment on the profitability for insiders through insider

transactions. We are interested in Hong Kong because most studies on insider trading are based

on U.S. data, and the results of these studies may not be robust in the Asian or emerging markets.

It has been widely accepted and supported that efficiency and transparency are low in most

emerging markets. In many cases, especially in small firms, the separation of management and

ownership is rare. Since manager-owners are, in general, more informed about the business

prospects of their own firms, insider trading which involves the directors of small corporations is

likely to be the most profitable. In a current study by Claessens et al. (2000), it is reported that

about 60% of Hong Kong firms are group-affiliated, while 66% of Hong Kong firms are

controlled by families. Hence, a study of insider trading in Hong Kong can shed light on the

impact of information asymmetry on the profitability of insider transactions.
                                                                                                  2

           Our results show that insiders can make abnormal profits from both buying and selling

activities. The magnitude of these abnormal profits associated with insider sales is considerably

larger than that associated with insider purchases. When insider transactions are grouped by

industry, firm size, book-to-market ratio, price-earnings ratio, and relative intensity of insider

transactions, we find that both the magnitude of the abnormal profits and the duration for which

these abnormal profits persists depend significantly on firm-specific and transaction-specific

factors.

           Small firms are found to generate the largest and most persistent abnormal profits. In

addition, abnormal returns can persist up to 20 days after an insider transaction has occurred.

Outside investors can make abnormal profits by mimicking insider activities. The overall results

imply that tougher regulations on insider trading may be necessary to enhance the efficiency of

the Hong Kong stock market.

           The remainder of this paper is organized as follows. Section 2 contains a summary of the

two Ordinances relating to insider trading in Hong Kong. Section 3 describes the data and

provides the summary statistics. Section 4 describes the methodology, followed by results and

discussions in Section 5. Section 6 concludes the study.




2. Insider Trading Regulations in Hong Kong

           Insider trading is criminalized in some parts of the world, but not in Hong Kong. The

main provisions in Hong Kong relating to insider trading are contained in the Securities (Insider

Dealing) Ordinance (SIDO), and the Securities (Disclosure of Interests) Ordinance (SDIO).

           Both ordinances were implemented on September 1, 1991 to replace the then existing

provisions of the Securities Ordinance. The purpose of the current legislation is to ensure a “level
                                                                                                   3

playing field” for all participants in the market, so that no one is allowed to benefit from trading

a firm’s securities by making use of undisclosed private information about the firm.

       According to SIDO, insider dealing occurs when a person or corporation, either directly

or indirectly connected to a listed corporation, uses relevant information about that corporation to

deal in the securities, or their derivatives, of that corporation, or to counsel or procure any other

person to trade the securities or their derivatives. Relevant information is defined as specific

information, which is not generally known to investors who might deal in the securities

concerned, and is likely to materially affect the price of those securities.

       While insider dealing is not a criminal offence in Hong Kong, the Insider Dealing

Tribunal (the Tribunal) is empowered to inquire into insider dealing cases and to impose orders

to penalize insider dealers. A person who is identified as an insider dealer may be prohibited

from being a director, liquidator, receiver, or manager of a company for a period not exceeding

five years, required to pay to the government an amount not exceeding the profit made or the loss

avoided relating to the insider dealing, and/or penalized for an amount of up to three times the

profit made or the loss avoided as a result of the insider dealing. Any persons who contravene the

investigation or the orders made by the Tribunal may be liable for a fine of up to $200,000 and to

a term of imprisonment of one year.

       The SDIO requires the disclosure of interests for substantial shareholders, directors, and

chief executives of a corporation. The Ordinance is applicable to interests in all companies listed

on the Stock Exchange of Hong Kong (SEHK), regardless of where the companies are

incorporated. A substantial shareholder is defined as anyone holding at least 10% of the share

capital of a corporation listed on the SEHK. Under the SDIO, directors and chief executives of

corporations face more stringent requirements than substantial shareholders. Directors and chief
                                                                                                  4

executives of a listed company are obligated to declare any interest in shares or debentures in the

listed company or any associated corporation, and their acquisition or disposal. Any shares or

debentures owned by the spouses, or any children under the age of 18, of directors and chief

executives are also taken to be interests of the directors or chief executives.

       Failure to comply with the SDIO is a criminal offence. If a listed company is in default in

complying with the Ordinance, then every officer concerned is liable to a fine of $2,000, and in

the case of continuing offence, to a further fine of $200 per day on each day the offence

continues. An individual who fails to make a timely notification, or makes a notification which is

false in material particulars, is subject to a fine of up to $100,000 and to a term of imprisonment

of up to two years.



3. Data and Summary Statistics

       As described in the previous section, directors, and chief executives of a listed company

are under an obligation to disclose any interests in the listed company, as well as the acquisitions

and disposals of such interests. Information on each notification received by the Stock Exchange

is disseminated to the general public through The Securities (Disclosure of Interests) (SDI) Daily

Summaries – Directors’/Chief Executives’ Notifications Report published by the Hong Kong

Exchanges and Clearing Limited (HKEx). Information in the SDI includes the company name,

the name of the insider, the type of securities, transaction date, reporting date, and publication

date. Data on the trading activities of corporate insiders used in this study are obtained from

Inside Trade Asia (ITA) of PRIMARK-DISCLOSURE. The ITA data are compiled based on the

original Securities (Disclosure of Interests) Daily Summaries – Directors’/Chief Executives’

Notifications Report published by the HKEx.
                                                                                                  5

        The sample period of this study is January 1993 through December 1998. To measure

returns to insider transactions, only open market purchases and open market sales, which are

represented by the transaction types P and S, respectively, in the ITA, are included for analysis in

this study.

        Many possible motivations exist behind an insider transaction. For insider sales, the

insider may sell stocks for liquidity reasons, or they may sell to diversify the risk of their

investment. For insider purchases, these occur naturally when directors buy shares for

qualification purposes. Insiders also acquire shares as a result of exercising options. However,

the general public and researchers tend to think that the more likely and intriguing reason behind

insider transactions is private information. If directors and chief executives are allowed to trade

in the securities of their own companies, then it is very likely that they trade the stocks of their

own firms to make a profit or to avoid a loss as soon as good news or bad news of the firm

reaches them. Even though insider trading is restricted or made illegal in many circumstances,

insiders are still likely to trade based on private, price sensitive information.

        Data on daily cash-dividend-adjusted stock returns (daily stock returns) and daily value-

weighted cash-dividend-adjusted market returns are obtained from the Pacific-Basin Capital

Markets (PACAP) Databases compiled by the University of Rhode Island. Other general

information, such as total stockholders’ equity, net income, industry type, daily trading volume

in shares, daily closing price of common stock, month-end common stock closing price, month-

end number of common stock outstanding, and month-end market value of stocks, are also

collected from the PACAP databases.

        For the sample period, there are 23,675 open market insider transactions. Table 1

provides the summary statistics of the insider trading data used in the study. In the sample, 541
                                                                                                   6

listed companies were involved in insider trading with 507 firms involved in open market

purchases and 458 involved in open market sales. The total number of open market purchases

and sales transactions are 16,221 and 7,574, respectively. In general, there are more insider

purchases than insider sales. The ratio of insider purchases to insider sales is about 2.15:1, such

that two out of three insider transactions are purchases`.

       For the entire sample, the average number of shares traded per transaction is 5.1 million

and, on average, the value of the shares traded in each transaction is HK$11.5 million. A

comparison by type of transaction shows that both the average number of shares per transaction

and the average value of the shares traded per transaction are larger for sales than for purchases.

Seyhun (1998) finds that insiders in the U.S. are likely to break up purchases into smaller

transactions for fear of insider trading sanctions. It is suggested that an insider purchase provides

a stronger signal to both the authority and the general public than does an insider sale. However,

insiders are not as concerned with insider trading regulations in sales transactions. It might be

taken by the authority that the motivations for profiting from the private information behind

insider sales are less obvious. Our results seem to lend support to this claim.

       Table 2 shows the frequency distribution of insider trading activity by industry

classification. The ratio of purchases to sales is the largest for the hotels industry group.

Directors and executives of consolidated enterprises are the most intensive sellers of their

companies’ stocks, while insiders of the properties group are the most intensive buyers. Overall,

relative to the insiders of other industries, corporate insiders of the properties industry are the

most active in trading the stocks of their own firms.

       Table 3 shows the frequency distribution of insider trading activities by firm size, book-

to-market ratio, price-earnings ratio and relative trading volume. Rozeff and Zaman (1988) argue
                                                                                                   7

that firm size is a contributing factor to the abnormal returns to outside investors. In a study by

Wong et al. (2000), it was found that the abnormal return on insider trading in Hong Kong is

significantly different for firms of different sizes and relative trading volume. To test for the

differences in firm size, the sample firms are classified into three groups according to their

market capitalization at the time of the insider transactions.

       Statistics show that insider purchases are more commonly found among small firms. The

ratio of purchases to sales for the small size firm group is 3.232:1. In contrast, directors in large

firms are more likely to sell. The ratio of purchases to sales for the large firm size group is

1.605:1.

       Fama and French (1995) argue that growth stocks are typically associated with a low

book-to-market ratio, whereas value stocks are typically associated with a high book-to-market

ratio. Since a high book-to-market ratio signifies under-valuation of a stock and positive future

returns, while a low book-to-market ratio indicates over-valuation and negative future returns of

a stock, it is likely that insiders purchase more when the stock’s book-to-market ratio is high and

sell more when the stocks’ book-to-market ratio is low (Seyhun, 1998). In our sample, each

transaction is ranked by the book-to-market ratio of the stock concerned and is assigned to one of

the three groups: low book-to-market ratio group, medium book-to-market ratio group, and high

book-to-market ratio group.

       The statistics of Table 3 are consistent with the hypothesis stated above. There are far

more purchases among the high book-to-market ratio group than among the low book-to-market

ratio group. Insider purchases increase in frequency with increasing book-to-market ratio, while

insider sales decrease in frequency with increasing book-to-market ratio. This is consistent with

the findings in Rozeff and Zaman (1998) and Seyhun (1998). In the sample, the ratio of
                                                                                                 8

purchases-to-sales is 4.052:1 for the high book-to-market ratio group, while it is 1.061:1 for the

low book-to-market ratio group.

       The price-earnings ratio of a firm is another widely used indicator of future stock returns.

Similar to the previous sections, each transaction is ranked by the price-earnings ratio of the

stock concerned and is assigned to one of three groups: low price-earnings ratio group, medium

price-earnings ratio group, and high price-earnings ratio group.

       Table 3 shows the frequency distribution of insider trading activity by the price-earnings

ratio of the firms concerned. The statistics are consistent with the assumptions made regarding

the relationship between the price-earnings ratio and insider trading activity. On the one hand,

insider purchases are more frequent in the low price-earnings ratio group, while fewer sales are

found. On the other hand, insider sales are more prominent in the high price-earnings ratio group,

while fewer purchases are found. The ratio of purchases to sales for the low price-earnings ratio

group is 2.566:1, while that for the high price-earnings ratio group is 1.307:1.

       Trading volume is found to be positively associated with the quality of information (see

Karpoff, 1987, for example). Wong et al. (2000) suggest that the trading volume of individual

transactions affects the post-event abnormal stock prices. Similar to Wong et al. (2000) and other

studies, relative trading volume is calculated by the total number of shares traded in the insider

transaction divided by the total number of outstanding shares of the stock. Relative trading

volume is used as an indicator of the quality of information associated with insider trading.

       Each transaction is ranked by the relative trading volume in shares and is assigned to one

of three groups: low relative trading volume ratio group, medium relative trading volume group,

and high relative trading volume group.
                                                                                                    9

         Table 3 shows the frequency distribution of insider transactions by relative trading

volume in shares. As discussed before, insiders might tend to sell in larger lots, and buy in

smaller lots. This pattern is indeed found in the sample. The ratio of purchases to sales is 2.357:

1 for smaller relative trades while it is 1.828:1 for larger relative trades.



4. Methodology

         Standard event study methodology is applied to examine the profitability for insiders

from the buying or selling of the stocks of their own firms. One main assumption behind insider

trading activity is that insiders buy and sell the stocks of their firms because insiders have private

information. However, it is still very possible that insiders trade for other reasons. Jaffe (1974)

suggests that information can initiate simultaneous buying and selling activities by insiders of the

same firm. During these periods, when insiders of a firm trade intensively, these insiders are

more likely to take advantage of having private information. Similar to many previous studies

(e.g. Jaffe, 1974; Lin and Howe, 1990), we will select a sample based on an intensive trading

criterion to reduce noise from trades not initiated by private information.

         In this study, a firm with at least 2 times more purchases in dollar value than sales in

dollar value in a month is classified as an intensive buying firm for that month. Conversely, a

firm with at least 2 times more sales in dollar value than purchases in dollar value in a month is

classified as an intensive selling firm for the month.

         In event time, day 0 is the transaction date of an “intensive” trading event. An estimation

period from day –280 to day –21 is used to calculate the parameters, αj and βj of the market

model:

                                    R jt = α jt + β j Rmt + ε jt ,                                (1)
                                                                                               10

where Rjt is the daily dividend-adjusted stock return for firm j on day t; Rmt is the daily value-

weighted dividend-adjusted market return on day t; αj is the estimated intercept; βj is the

estimated market risk of the stock j; and εjt, the error term on day t, is assumed to be normally

distributed with mean zero and constant variance σj2.

       The abnormal return to firm j on day t, ARjt, is then calculated from day –20 to day +20

for each day as follows:


                                  AR jt = R jt − α j − β j Rmt ,
                                                 ˆ     ˆ                                       (2)




where α j and β are the estimates of α j and β j . The average abnormal return (AAR) across
      ˆ       ˆ
                 j



firms for each day is:



                                           1N
                                    AARt =  ∑ AR jt ,                                        (3)
                                            N  j =1



where N is the number of firms with insider trading on day t. The significance of the average

abnormal return is tested by the statistic:



                                                   AARt
                                        t AARt =           .                                   (4)
                                                   σ AAR
                                                       t




       The cumulative average abnormal return (CAAR) to the insider trading firms from day –

D to day D is the sum of the average abnormal returns between day –D and day D. The formula

is:
                                                                                                11

                                                   D
                                   CAARt =       ∑ AAR
                                                 t =− D
                                                           t
                                                               ,                                (5)




and the significance of the cumulative average abnormal return is:



                                                 CAARt
                                     t CAARt =             .                                    (6)
                                                 σ CAARt



       Insiders are required to report any insider transactions to the SEHK within 5 days

following the transaction. Here we make the prudent assumption that the average outsider would

not know of any occurrence of insider trading on day 1 to day 5 after the insider transaction day,

and that by day 20 after the transaction day, the SEHK should have disseminated information

about the transaction to the public through the SDI report. To assess the performance of stocks

traded by insiders and the degree of market efficiency in the stock market, we will examine the

cumulative average abnormal returns associated with insider purchases and sales for post-event

periods of day 1 to day 5, day 1 to day 10, and day 1 to day 20. The CAARs of the transactions

will be analyzed as a whole, by industry classification of the transaction firm, by size of the

transaction firm, by price-earnings ratio of the transaction firm, by book-to-market ratio of the

transaction firm, and by relative trading volume of the transaction. If we find persistent abnormal

returns after the day on which the public is informed of any insider trading, then the market

reacts to the dissemination of such information. Also, if such abnormal returns exist, then it is

likely that outsiders can actually earn abnormal profits by mimicking the trades of insiders.
                                                                                                 12


5. Results and Discussion

       Table 4 shows the cumulative average abnormal returns surrounding insider purchases

and insider sales. The overall result shows that within the 20-day post-event period prices

increase after insider purchases and decrease after insider sales. For insider purchase transactions,

the 20-day pre-event CAAR is statistically significantly negative, which means that insider

purchases occur after a period of persistently low stock price. On day 0, the AAR is –0.056% (t =

-1.37), which is not significantly different from zero. However, the 5-day, 10-day, and 20-day

CAARs are 0.19%, 0.43% and 0.58% respectively, which are all significantly positive. In the

aggregate, stocks purchased by insiders do perform well within the 20-day period after the

transaction. Insiders are able to make abnormal profits from insider purchases. Since the CAARs

of insider purchases are significantly positive within a 20-day period after the transaction, a

period long enough for outsiders to know of the occurrence of insider purchases and to mimic the

trades, outsiders are also capable of making abnormal profits from following insider purchases.

       Price movements around insider sale transactions are more dramatic. The pre-event

CAAR is significantly positive. While the AAR for day 0 is 0.76% (t = 8.78), all the post-event

CAARs are significantly negative. Within a 5-day period after the sales transaction, the CAAR is

-1.14%. The 10-day and 20-day CAARs are both significantly negative, at around -2.28% and -

4.14%, respectively. The results suggest that stocks sold by insiders do indeed perform poorly

after the transactions have taken place. Insiders are able to obtain profits (or avoid losses) when

they enter into transactions to sell the stocks of their own firms. Since the CAARs exist in a

prolonged period of 20 days after the transactions have occurred, it is also very likely that

outsiders who sell stocks following insiders can make abnormal profits.
                                                                                                 13

       When insider trading of the Hong Kong stock market is examined in the aggregate sense,

contrary to the widespread belief that corporate insiders are making huge profits from their

insider purchase transactions, we find that insiders actually obtain more profits from insider sales

transactions. The result shows that in the aggregate, although insiders are able to earn abnormal

profits from both insider buying and selling activities, the magnitude of short-run abnormal

profits associated with insider sales is considerably larger than that associated with insider

purchases.

       Table 5 presents the cumulative average abnormal returns for insider trading events

according to industry classifications of the transaction firm. Only insiders of the finance and

industrials industries are able to make significant abnormal profits through insider purchases. For

finance industry insider purchases, the CAARs over the 5 days, 10 days, and 20 days after the

transaction day are all significantly positive at around 0.96%, 1.26%, and 2.81%, respectively.

For the industrial industry, the 5-day post-event CAAR is not significantly different from zero,

but the CAARs over 10 days and 20 days after the transaction day are significantly positive at

around 0.75% and 0.17%, respectively. Insiders of the utility, properties, consolidated enterprises,

and hotels industrials are not able to gain abnormal profits from insider purchases.

       In terms of sale transactions, insiders of the properties, consolidated enterprises, and

industrials industries tend to sell when prices are high. The pre-event CAARs associated with

sales for these three industry groups are significantly positive, and all post-event CAARs are

significantly negative. The post-event CAAR associated with insider sales is the most negative

for the industrials group. The 5-day, 10-day, and 20-day post-event CAARs are all significantly

negative at around –2.83%, -6.12%, and -9.95% respectively. For the properties industry, the

post-event CAARs for 5 days, 10 days, and 20 days after the transaction day are significantly
                                                                                                    14

negative at about –1.41%, -2.16%, and -3.99% respectively. For the consolidated enterprises

industry, the post-event CAARs for 5 days, 10 days, and 20 days are significantly negative at

about –1.13%, -2.42%, and -4.01% respectively. Insiders of the finance, utility, and hotels

industries, however, are not found to be able to gain significant abnormal profits from insider

sales.

         On the whole, the results show that abnormal profits are mainly associated with insider

transactions in the finance, industrial, consolidated enterprises, and properties industries. As far

as profit opportunity for outsiders is concerned, they are more likely to make abnormal profits

when buying by following insiders who belong to the finance and industrial industries, and when

selling by following insiders of the properties, consolidated enterprises, and industrial industries.

         Panel A of Table 6 shows the cumulative average abnormal returns associated with

insider trading grouped by the size of firms involved in the trading. For insider purchases, only

the small firms indicate significantly positive post-event CAARs. For this group, the 10-day, and

20-day post-event CAARs are all significantly positive at 1.19%, and 2.65% respectively.

Insiders of medium-size firms and large-size firms are not able to make abnormal profits from

purchasing stocks of their own firms. The findings here regarding the relationship between firm

size and insider purchases are consistent with those reported in Wong et al. (2000). They also

find that insider purchases in small firms show the largest abnormal returns.

         Relating firm size to insider sales, regardless of the size of the firm, insiders of all firms

are selling stocks at high prices. All the pre-event CAARs are positive before the transaction day,

while all the post-event CAARs are negative. Comparing the three firm size groups, the post-

event CAARs are found to be the most negative for the small-size firms and the least negative

for the large-size firms. For the small-size firms group, all post-event CAARs are significantly
                                                                                                  15

negative. The 5-day, 10-day, and 20-day CAARs are 2.06%, 3.97%, and 6.90% respectively. For

the large-size firms group, however, only the 10-day and 20-day CAARs are significantly

negative at 0.83% and 2.22%, respectively.

       When transactions are grouped by firm size, the overall result shows that the abnormal

returns associated with both insider buying and selling activities are concentrated in small firms.

Insiders in small firms are more likely to buy or sell stocks to take advantage of private

information, and they do earn abnormal profits from such trading. This result is in line with

findings that information asymmetry is more severe among small firms, e.g. Wong et al. (2000).

       Outsiders who wish to make abnormal profits by following insiders in buying or selling

should only follow the insiders of small firms. If outsiders wish to follow insiders in selling, then

the outsiders are likely to make abnormal profits in most circumstances, but following insiders in

small-firms when selling is likely to bring the highest amount of abnormal profits.

       As stated previously, the future prospect of a firm is associated with its book-to-market

(B/M) ratio. Low book-to-market ratio predicts bad performance, while large book-to-market

ratio predicts good performance. It is hypothesized that insiders tend to sell at periods of low

B/M ratio and buy at high B/M periods. Now we examine the relationship between the

cumulative average abnormal returns associated with insider trading and the B/M ratio. Panel B

of Table 6 shows the CAARs for insider trading events grouped by the B/M ratio of the firm

involved in the trading. The results show that stocks bought by insiders of large B/M ratio firms

perform better than the stocks bought by low and medium B/M ratio firms in the 20-days after

the transaction day. The 10-day and 20-day post-event CAARs associated with insider purchases

are significantly positive at around 0.43% and 0.78%, respectively. For low and medium B/M

firms, the CAARs for stocks bought by insiders are not significantly different from zero.
                                                                                                     16

Therefore, the combination of large book-to-market ratio and insider buying gives a signal to

predict positive stock price performance in the 20 days after the transaction.

           For stocks sold by insiders, the CAARs are all significantly negative for the small and

medium B/M groups up to a 20-day period after the transaction day. The small B/M group shows

the most negative abnormal returns. The 5-day, 10-day, and 20-day CAARs are –1.21%, -3.19%

and –6.00%, respectively. Compared to these results, the 20-day CAARs for the medium and

high B/M ratio firms are relatively lower at just –3.80% and –0.99%, respectively. This is

consistent with the hypothesis that a small book-to-market ratio predicts bad future performance.

In general, an insider transaction combined with the value of the book-to-market ratio of the firm

involved in the insider trading provides a stronger indicator of the stock performance than insider

trading alone.

           In terms of the profitability to outsiders, mimicking insider purchases are profitable if the

firm involved has a large B/M ratio. Following insiders when selling brings abnormal returns to

outsiders regardless of the book-to-market ratio of the firm, but outsiders who follow selling

transactions involving small B/M firms are likely to obtain the greatest amount of abnormal

profits.

           A low price-earnings (P/E) ratio is associated with a high future stock return, while high

P/E is associated with a low future stock return. Therefore, it is likely that insiders buy when the

P/E of the stock is low, and sell when the P/E is high. Panel C of Table 6 shows the CAARs for

insider trading events grouped by the P/E ratio of the firms involved in the insider trading.

Overall, positive post-event CAARs associated with insider purchases are found only in the

small P/E group, but only the 10-day post-event CAAR is significantly positive at 0.60%. For the

medium P/E group, the 5-day CAAR is positive while the 10-day and 20-day CAARs are
                                                                                                  17

negative. However, none of the CAARs for this group are significantly different from zero. For

the large P/E group, the 5-day and 10-day CAARs are not significantly different from zero, but

the 20-day CAAR is significantly negative at –1.40%.

       For sales transactions, post-event CAARs are all significantly negative for all P/E groups.

Contrary to the hypothesis that insiders tend to sell high P/E stocks since those stocks are more

likely to perform poorly in the future, the results show that the post-event CAARs associated

with insider sales are the most negative for the low P/E firms. The 5-day, 10-day, 20-day post-

event CAARs are –1.69%, -3.42%, and –5.44% respectively. For the medium and high P/E

groups, the 20-day CAARs are around just –3.23% and –4.33% respectively.

       In general, when the insider transactions are grouped by P/E ratios, insider purchases

among the low P/E firms are likely to generate the largest amount of abnormal profits for the

insiders. Insider sales are signals of negative stock performance in the future, but the P/E ratio of

the firm concerned does not enhance the predictability of the insider sale signal. In terms of

profit opportunities for outside investors, outsiders are most likely to make abnormal profits by

mimicking the insiders of small firms when purchasing.

       Karpoff (1987) suggests that the quality of private information is positively related to

trading volume. Relative trading volume, calculated by the total number of shares traded in the

insider transaction divided by the total number of outstanding shares of the stock, is used as an

indicator of the quality of private information associated with insider trading. The relation

between relative trading volume and the abnormal price performance of the stock following

insider transactions is examined next. Panel D of Table 6 shows the cumulative average

abnormal returns for insider trading grouped by the relative trading volume of the transaction.
                                                                                                 18

       For insider purchases, only the 10-day post-event CAAR for the medium relative trading

volume group is significantly positive, at around 0.56%. Purchases in the large relative trading

volume group do not predict good performance within a 20-day post-event period. Therefore, the

relative trading volume of insider purchases per se may contain little information. For sales

transactions, post-event CAARs for the small, medium, and large relative trading volume groups

are all statistically significant. Post-event day CAARs are the most negative for the large relative

trading volume group. The 5-day, 10-day and 20-day CAARs are -1.59%, -3.44%, and –6.29%

respectively. In general, the relative trading volume combined with insider selling seems to

convey more information, and the worst future stock performances are followed by larger insider

sales. Regardless of the relative trading volume of the transactions, insiders are all able to earn

abnormal profits from selling the stocks of their firms.

       Outsiders are able to obtain abnormal profits when they follow insiders in selling

regardless of the relative trading volume of that transaction, but following insiders who sell in

large lots is likely to bring the highest abnormal profits for the outsiders. Yet, outsiders who

mimic insiders when buying, following large purchases by insiders, are not likely to earn

abnormal profits.



6. Concluding Remarks

       Reported insider trading on the Hong Kong stock market between the period of 1993 and

1998 is examined in the study. The overall result shows that, even though there exists legislation

to regulate transactions by corporate insiders, the directors, chief executives and substantial

shareholders are still able to make abnormal profits from insider trading activities. In the

aggregate, we find that insiders are able to earn abnormal profits from both insider buying and
                                                                                                   19

selling activities in the short-run of up to 20 days after the transaction day. By examining the

abnormal performance of stocks traded by insiders according to industry classification, firm size,

book-to-market ratio of the firm, price-earnings ratio of the firm, and relative trading volume of

the insider transactions, we see that some insider purchases produce large and persistent

abnormal profits; the characteristics of these purchases are that the firm concerned is a finance or

industrials company, the firm is small in terms of market value, the book-to-market ratio of the

firm is large, the price-earning ratio of the firm is small, and the relative trading volume of the

purchase is large. In terms of the profit opportunities for outsiders, they should be able to make

abnormal profits by following most of the insider sales transactions when selling, but only

selected insider purchase transactions when buying.

       For insider sales, the post-event cumulative average abnormal returns are significantly

negative in the aggregate sample, as well as for by-groups that are formed according to firm and

transaction specific characteristics. Besides profitability for insiders, this suggests that outsiders

will also be able to make abnormal profits by mimicking insider sales. Overall, the results imply

that tougher regulations on insider trading may be necessary to enhance the efficiency of the

Hong Kong stock market.
                                                                                               20


References

Chang, S. and D. Suk, 1998, “Stock Prices and the Secondary Dissemination of Information: The
       Wall Street Journal’s “Insider Trading Spotlight” Column,” Financial Review 33(3), 115-
       128.

Claessens, S., S. Djankov and L. Lang, 2000, “The Separation of Ownership and Control in East
       Asian Corporations,” Journal of Financial Economics 58, 81-112.

Fama, E. and K. French, 1995, “Size and Book-to-Market Factors in Earnings and Returns,”
      Journal of Finance 50, 131-155.

Finnerty, J., 1976a, “Insiders’ Activity and Inside Information: A Multivariate Analysis,”
       Journal of Quantitative Financial Analysis 11, 205-216.

Finnerty, J., 1976b, “Insiders and Market Efficiency,” Journal of Finance 31, 1141-1148.

Jaffe, J., 1974, “Special Information and Insiders Trading,” Journal of Business 47 410-428.

Karpoff, J., 1987, “The Relation between Price Changes and Trading Volume: A Survey,”
       Journal of Financial and Quantitative Analysis 22, 109-126.

Lin, J. and J. Howe, 1990, “Insider Trading in the OTC Market,” Journal of Finance 45, 1273-84.

Rozeff, M. and M. Zaman, 1988, “Market Efficiency and Insider Trading: New Evidence,”
       Journal of Business 61, 25-44.

Rozeff, M. and M. Zaman, 1998, “Overreaction and Insider Trading: Evidence from Growth and
       Value Portfolio,” Journal of Finance 53, 701-716.

Seyhun, N., 1986, “Insiders’ Profits, Costs of Trading and Market Efficiency,” Journal of
      Financial Economics 16, 189-212.

Seyhun, N., 1988a, “The Information Content of Aggregate Insider Trading,” Journal of
      Business 61, 1-23.

Seyhun, N., 1988b, “The January Effect and Aggregate Insider Trading,” Journal of Finance 43,
      129-141.

Seyhun, H. Nejat, 1998, Investment Intelligence from Insider Trading. Cambridge, Mass.: MIT
      Press.

Wong, M., Y. Cheung and L. Wu, 2000, “Insider Trading in the Hong Kong Stock Market,”
      Asia-Pacific Financial Markets 7, 275-288.
                                                                                               21

                                            TABLE 1


        Summary Statistics on Insider Trading Data from January 1993 to December 1998

                                                   Purchases       Sales       All Transactions

Number of Transactions                              16,221         7,574           23,675

Number of Firms with Insider Trading                  507           458              541

Average Number of Shares Traded per Transaction    4,427,747     5,589,757        5,136,724

Average Value of Shares Traded per Transaction    $9,225,137    $17,124,634      $11,487,213
Note:    Purchases and Sales refer to open market purchases and open market sales, respectively,
         by company directors, chief executives and substantial shareholders.
                                                                                                22




                                            TABLE 2

          Frequency Distribution of Insider Trading Events by Industry Classification


 Industry group    Purchases    Sales   All transactions   Ratio of purchases to   Number of
                                                                   sales           companies*
    Finance           701        433         1,134                 1.619              60
    Utilities         123        87           210                 1.414                 15
   Properties        5,276      1,666        6,942                3.167               108
  Consolidated       4,299      2,772        7,071                1.551               207
   Enterprises
   Industrials       4,838      2,196        7,034                2.203               259
     Hotels           921        158         1,079                5.829                 15
  Miscellaneous        63        132          195                 0.477                 10

Source: Various issues of SEHK Monthly Bulletin published by The Stock Exchange of Hong
Kong.

Note: * The figures in the column refer to the number of companies in that industry classification
as of the end of January 1998. Industry classification is assigned by the Stock Exchange
according to the nature of the business of the company.
                                                                                               23

                                            TABLE 3

 Frequency Distribution of Insider Trading Events by Firm Size, Book-To-Market Ratio, Price-
                        Earnings Ratio, and Relative Trading Volume

                                         Firm Size                   Book-To-Market Ratio
                              Lowest      Middle      Largest    Lowest    Middle    Largest
                                1/3         1/3         1/3        1/3       1/3        1/3
         Purchase              6,141       5,291       4,784      3,387     4,425     5,203
           Sales               1,900       2,571       2,981      3,191     2,030     1,284
     All Transactions          8,041       7,862       7,765      6,578     6,455     6,487
Ratio of Purchase to Sales     3.232       2.058       1.605      1.061     2.180     4.052

                                   Price-Earnings Ratio             Relative Trading Volume
                              Lowest      Middle    Largest      Lowest      Middle    Largest
                                1/3        1/3         1/3         1/3         1/3       1/3
         Purchase              4,712      4,607       3,691       5,527       5,586     5,103
           Sales               1,836      1,842       2,825       2,345       2,318     2,791
     All Transactions          6,548      6,449       6,516       7,872       7,904     7,894
Ratio of Purchase to Sales     2.566      2.501       1.307       2.357       2.410     1.828

Note: Firm size is measured by market capitalization. The firm size of an insider trading firm is
calculated for every transaction based on the month-end figures of the month prior to that when
the insider trading occurred. Book-to-market ratio is the ratio of the book value (i.e. total
stockholders’ equity) to market value. The book value of the insider trading firm, for every
transaction, is based on the fiscal year-end figures of the year prior to that year when insider
trading occurred. The price-earnings ratio is the ratio of the current share price to earnings per
share over the past year. Earnings-per-share of the insider trading firm for every transaction is
based on the fiscal year-end figure of the year prior to that year when insider trading occurred.
Relative trading volume in shares is defined as the number of shares traded in the insider trading
transaction divided by the total shares outstanding. Total shares outstanding is based on the
month-end figure of the month prior to that month when insider trading occurred, and is obtained
from the PACAP databases.
                                                                                                24

                                          TABLE 4

                 Cumulative Daily Abnormal Returns for Insider Trading Events

                                       Insider Purchase                 Insider Sales
Event Window                       CAAR            t-statistic     Return         t-statistic
Pre-event Window (-20, -1)         -0.0311          -15.37**       0.0258           7.53**
Transaction Day (0)                -0.0006           -1.37         0.0076           8.78**
Post-event Window (+1, +5)         0.0019            2.01*        -0.0114           -8.41**
Post-event Window (+1, +10)        0.0043            3.14**       -0.0228          -11.29**
Post-event Window (+1, +20)        0.0058            2.72**       -0.0414          -13.42**

* Significant at the 5% level.
** Significant at the 1% level.
                                                                                                     25


                                             TABLE 5

       Cumulative Daily Abnormal Returns for Insider Trading by Industry Classification


                                     Finance                                    Utilities
                      Insider Purchase     Insider Sales         Insider Purchase       Insider Sales
Event Window          CAAR       t-stat   CAAR      t-stat       CAAR       t-stat    CAAR       t-stat
(-20, -1)              -0.065    -7.17**    0.061      6**        0.004      0.36       0.025     1.25
Transaction (0)        -0.003     -1.41     0.008    4.07**      -0.003     -1.16       0.006     1.36
(+1, +5)                0.010     2.35*     0.001     0.39       -0.001     -0.27       0.005     0.74
(+1, +10)               0.013     1.82      0.003     0.55       -0.003      -0.7      -0.008    -0.68
(+1, +20)               0.028     3.2**     0.002     0.18        0.001     0.07       -0.024    -1.61

                                   Properties                         Consolidated Enterprises
                      Insider Purchase     Insider Sales         Insider Purchase   Insider Sales
Event Window           CAAR        t-stat   CAAR       t-stat    CAAR         t-stat   CAAR        t-stat
(-20, -1)              -0.014    -5.95**     0.015      1.94     -0.043    -10.06**     0.014     2.77**
Transaction (0)         0.000       0.14     0.003       1.8     -0.002       -1.92     0.009     5.45**
(+1, +5)                0.002       1.49    -0.014   -5.09**      0.003        1.37    -0.011    -4.95**
(+1, +10)               0.003       1.49    -0.022   -5.01**      0.004        1.12    -0.024    -7.43**
(+1, +20)               0.004       1.26    -0.040   -5.83**     -0.004       -0.79    -0.040    -8.51**

                                  Industrials                                  Hotels
                      Insider Purchase     Insider Sales         Insider Purchase     Insider Sales
Event Window           CAAR        t-stat   CAAR       t-stat    CAAR         t-stat   CAAR        t-stat
(-20, -1)              -0.044    -8.34**     0.039    5.55**     -0.007       -1.62     0.028        1.9
Transaction (0)         0.000        0.2     0.010    6.83**     -0.001        -1.2     0.003       0.77
(+1, +5)               -0.000      -0.21    -0.014   -5.37**      0.004        1.37    -0.001      -0.09
(+1, +10)               0.008      2.49*    -0.031   -7.64**      0.001        0.17    -0.002       -0.2
(+1, +20)               0.017     3.54**    -0.060   -9.24**     -0.000       -0.02     0.025        1.4

* Significant at the 5% level, ** Significant at the 1% level.
                                                                                                                                            26

                                                                 TABLE 6

   Cumulative Daily Abnormal Returns for Insider Trading Events by Size, Book-to-Market Ratio, Price Earnings Ratio and
                                          Relative Trading Volume of the Firm
                                                       Panel A: Firm Size
                                Smallest 1/3                         Middle 1/3                                         Largest 1/3
                    Insider Purchase     Insider Sales   Insider Purchase    Insider Sales                  Insider Purchase     Insider Sales
Event Window         CAAR        t-stat    CAAR        t-stat     CAAR       t-stat    CAAR       t-stat    CAAR        t-stat    CAAR            t-stat
                                      **                                          **                   **                    **
(-20, -1)             -0.062   -12.04        0.016       1.79      -0.022   -5.75        0.025    4.16       -0.019    -9.01        0.031         6.94**
Transaction (0)        0.001       0.74      0.005      2.14*      -0.001     -0.87      0.009    6.76**     -0.002    -3.61**      0.008         8.37**
(+1, +5)               0.003       1.52     -0.021    -6.21**       0.001      0.75     -0.015   -6.21**      0.001       1.15     -0.003          -1.77
(+1, +10)              0.012     3.57**     -0.040    -7.73**      -0.000      -0.1     -0.029   -8.23**      0.002       1.43     -0.008        -3.33**
(+1, +20)              0.027     5.07**     -0.069    -8.61**      -0.003     -0.69     -0.049   -9.19**     -0.000       -0.1     -0.022        -5.59**

                                                 Panel B: Book-To-Market Ratio
                                Smallest 1/3                          Middle 1/3                                        Largest 1/3
                    Insider Purchase     Insider Sales    Insider Purchase    Insider Sales                 Insider Purchase     Insider Sales
Event Window          CAAR        t-stat    CAAR        t-stat     CAAR       t-stat    CAAR       t-stat    CAAR        t-stat    CAAR            t-stat
(-20, -1)            -0.0338    -7.06**     0.0354     5.98**     -0.0230   -6.81**     0.0210    4.01**    -0.0307   -10.25**     0.0196         3.27**
Transaction (0)      -0.0014      -1.66     0.0104      8.3**     -0.0015    -2.13*     0.0095    6.83**     0.0002       0.37     0.0044         2.96**
(+1, +5)             -0.0020       -1.1    -0.0121    -5.14**     -0.0005     -0.31    -0.0097   -4.66**     0.0015       1.14    -0.0097        -3.55**
(+1, +10)            -0.0047      -1.69    -0.0319    -9.41**      0.0000         0    -0.0191   -6.07**     0.0043      2.14*    -0.0129         -3.5**
(+1, +20)            -0.0200     -4.6**    -0.0600   -11.75**     -0.0030     -0.73    -0.0380   -7.99**     0.0078      2.56*    -0.0099          -1.62
                                                                                                                                             27



                                                    Panel C: Price Earnings Ratio
                                  Smallest 1/3                          Middle 1/3                                       Largest 1/3
                      Insider Purchase     Insider Sales   Insider Purchase     Insider Sales                Insider Purchase     Insider Sales
Event Window            CAAR        t-stat    CAAR       t-stat    CAAR        t-stat    CAAR       t-stat    CAAR        t-stat    CAAR            t-stat
(-20, -1)              -0.0437     -9.9**     0.0173     2.36*    -0.0208    -7.32**     0.0153    3.14**    -0.0237    -6.68**     0.0430         7.56**
Transaction (0)        -0.0010     -1.33      0.0082    5.05**    -0.0009      -1.32     0.0063     4.8**    -0.0002      -0.23     0.0111         9.07**
(+1, +5)                0.0016       0.98    -0.0170   -5.57**     0.0003       0.21    -0.0078   -3.77**    -0.0026      -1.61    -0.0084        -3.89**
(+1, +10)               0.0060       2.2*    -0.0343   -8.12**    -0.0011      -0.57    -0.0207   -6.71**    -0.0039       -1.7    -0.0183        -5.64**
(+1, +20)               0.0052       1.16    -0.0544   -8.57**    -0.0018      -0.66    -0.0303   -6.77**    -0.0140    -3.48**    -0.0433        -8.22**

                                                  Panel D: Relative Trading Volume
                                  Smallest 1/3                          Middle 1/3                                       Largest 1/3
                      Insider Purchase     Insider Sales    Insider Purchase    Insider Sales                Insider Purchase     Insider Sales
Event Window            CAAR        t-stat   CAAR        t-stat   CAAR         t-stat   CAAR        t-stat    CAAR        t-stat   CAAR          t-stat
(-20, -1)               -0.036   -14.71**     0.018     4.72**    -0.035    -12.44**     0.019     3.85**     -0.018    -4.95**     0.031       5.73**
Transaction (0)         -0.002    -2.97**     0.007     8.06**    -0.002     -3.71**     0.009     8.43**      0.001       1.91     0.011       6.86**
(+1, +5)                 0.002       1.56    -0.008    -4.99**     0.002        1.08    -0.011    -5.53**      0.000      -0.03    -0.016      -7.33**
(+1, +10)                0.004       1.79    -0.012    -5.82**     0.006      2.69**    -0.021    -7.07**      0.003        1.2    -0.034     -10.65**
(+1, +20)                0.003       1.06    -0.031    -9.56**     0.003        1.02    -0.039    -7.77**      0.006       1.68    -0.063     -12.39**


* Significant at the 5% level, ** Significant at the 1% level.

				
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