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The Timing of Directors‟ Sharedealings and Company Valuation 15 The Timing of Directors‟ Sharedealings and Company Valuation Jorge Belaire-Franch* University of Valencia, Spain Philip Hamill++ University of Glasgow, Scotland Philip McIlkenny+* University of Glasgow, Scotland University of Ottawa, Canada Kwaku K. Opong+ University of Glasgow, Scotland Abstract Directors are assumed to have more information about their company‟s prospects than any other market participant. Thus it would appear that directors are well placed to profit from insider trading. This suggests, therefore, that company directors may time their dealing activities to coincide with periods which will be most profitable to them. Directors will therefore buy when they perceive the firm‟s share price to be undervalued and sell when the price is overvalued. This study seeks to provide evidence on the ability of company directors to time their purchasing (selling) activities to coincide with periods when they perceive the value of their firms as relatively low (high) compared to their valuation on the basis of their superior information. In the presence of strong form market efficiency, the timing ability of directors share dealings will be redundant. The sample comprises those firms that constitute the FTSE 250. Whilst not conclusive, the results of the study appear to indicate that directors do have some timing ability in their share dealings. However, no significant positive abnormal returns are earned following directors‟ share dealing announcements. Keywords Insider Trading, Market Efficiency, Timing ability, Directors‟ share dealings Introduction Directors are assumed to have more information about their company‟s prospects than any other market participant. Thus it would appear that directors are well placed to profit from insider trading. The financial press (Nuki 1994) suggests that a profitable trading strategy is possible for market participants who follow directors‟ trading pattern. This is only possible if directors could time their share dealing activities due to their superior knowledge about the prospects of their firms. Thus, this paper seeks to provide some evidence or otherwise of directors timing ability in their share dealing activities. The next two sections discuss the rationale for the study and the regulation of directors' share dealing activities respectively. This is followed by a discussion of the extant literature on insider trading. The methodology employed in the study is also described in the next section. This is followed by a discussion of the results and conclusions respectively. 16 Belaire-Franch, Hamill, McIlkenny and Opong / Journal of Accounting and Finance 3 (2004) 15~31 Do Directors Time Their Share Dealing Activities? A major rationale for this study is whether directors time their share dealing activities to coincide with periods when the value of the firm is at its highest when they sell and lowest when they buy. If this is the case, then, it would appear that it could be profitable to mimic what directors do. A central point in mimicking what directors do is the assumption that directors know whether their companies are over- or under-valued. This assumption is based on the notion that directors are much more informed about the prospects of their companies and therefore can trade on the basis of insider information1 by buying undervalued shares or selling overvalued shares. The timing ability of directors is not made explicit in previous studies. The UK regulator, The Financial Services Authority (FSA) got tough new powers in 2001 to act against directors who breach stock exchange rules on share dealing. The move will extend the financial watchdog's remit to cover individuals who have broken the rules but then leave the company before any investigation into their behaviour is completed. Under the rules the FSA has the power to levy fines on former directors as well as companies and directors who remain in post. Prior to 2001, the FSA could only censure companies and directors who had broken the rules. The change comes against a background of high-profile cases where institutional investors have questioned directors' share sales and insisted on board changes. In November 2000, Hartmut Lademacher was forced out as non-executive director at Sema, the Anglo-French software company, after selling 1.8m shares for £24m in the run-up to the interim results in September 2000. Malcolm Walker, the chairman of Iceland caused a furore about his sale of 4m shares in mid- December 2000, five weeks ahead of a profit warning, and was forced to resign on 31 st January 2001 from the company he founded 30 years ago. Iceland insisted that Mr Walker had done nothing wrong and said that the sale was in preparation for his long-standing plans to move to a non-executive role in March. Iceland board pointed out that the sale was approved by the board and would not have been authorised if it knew that it was about to publish information that would affect the company's share price. This appears to indicate an incredible ignorance about what is happening in the company. The sale sparked a row because the average price Mr Walker received was 339p, a five year price high for Iceland. The shares slumped by about 40% just before Mr Walker resigned. Mr Walker left by agreement that he will not be receiving compensation for loss of office. Due to information asymmetry that exists between directors and investors, knowing what directors are doing is important since it can indirectly reveal what they know. Information about directors' trades is widely available in the financial press and is followed with interest by investors. In September 1997, Chrysler Corporation had to issue a public statement following the sale by directors of unusually large quantities of shares that the sale was not to be interpreted as a bearish signal. The issue as to whether directors can time their trades is an empirical one and the current study attempts to add to the scant but growing literature in this area. Two hypotheses are tested in this study. First, if directors, by virtue of superior information can time their trades, we should expect that directors‟ purchases should coincide with periods when prices are low and sales will be during periods when prices are at their highest. The second hypothesis tested in this study is that if directors trade in their securities, it should make those securities much more liquid and lead to an increase in trading volume around the period when they deal because some investors will attempt to mimic what they do. 1 Insider trading is illegal under the law. Directors can only trade outside a closed period. The Timing of Directors‟ Sharedealings and Company Valuation 17 UK Regulation of Directors’ Sharedealing Activities Sections 198-220 of the Companies Act 1985 contain provisions for securing the disclosure and registration of substantial individual interests in share capital that carry unrestricted voting rights. The relevant sections require notification to the company of any acquisition or divestiture of three percent in writing within two business days. The relevant sections also require notification of family and corporate interests as well as members acting in a concert party. Section 142 of the Financial Services Act (1986) and the Financial Services and Markets Act (2000) empowers the Stock Exchange itself to draw up listing rules for the admission of securities to listing on the Exchange. There are provisions in the listing rules that deals with directors continuing obligations among which is a model code on directors‟ share dealings activities. The purpose of the Code is to ensure that directors, certain employees and persons connected with them do not abuse, or even place themselves under suspicion of abusing, price-sensitive information that they may have or be thought to have. This is especially important in periods leading up to an announcement of company financial reports. The principal restrictions on dealings cover the following areas: (a) A director must not deal in his company's securities on considerations of a short term nature or at any time when he is in possession of unpublished price-sensitive information in relation to those securities or during a 'close period' i.e. the period of two months before the announcement of the company's results for a financial period (or one month in the case of quarterly reports) or, if shorter, the period from the end of the relevant financial period to the time of the announcement. (b) A director needs clearance from his or her chairperson or other director designated for the purpose before they can deal in the securities of their company. (c) In exceptional circumstances, clearance may be given for a director to sell (but never to purchase) securities when he would otherwise be prohibited from doing so only because the proposed sale would fall within a close period. Note however that the company's obligation to notify the dealing must state the exceptional circumstances which were pertaining at the time of the dealing which may lead to personal circumstances being disclosed publicly. There are special rules where a director has funds under discretionary management or an interest under a trust or acts as a trustee, and also in the case of single company personal plans and other saving schemes. It should be noted that compliance with the Model Code does not of itself ensure compliance with the insider dealing legislation in the Criminal Justice Act (1993). The act stipulates that it is a criminal offence to deal or encourage another person to deal or disclose inside information unless no dealing is expected. Even though directors may have the incentive to trade on inside information, in the presence of market efficiency, such an attempt may not be worthwhile. Also, It can be argued that a company that gets a reputation for 'leakiness' (ie. where inside deals in its securities are regularly suspected) may find it difficult or expensive to raise new capital. The Stock Exchange attempts to control insider trading and has published a document providing guidance on the dissemination of price-sensitive information, with the intention that all listed companies follow the same strict guidelines. The managerial market may also penalize managers who betray their fiduciary duty to shareholders by trading on inside information. 18 Belaire-Franch, Hamill, McIlkenny and Opong / Journal of Accounting and Finance 3 (2004) 15~31 Literature Review Prior studies on insider trading in the U.K. seem to suggest that insiders can earn significant positive abnormal returns by trading their own firm‟s securities (see King and Roell,1999; Pope, Morris and Peel, 1990; Gregory, Matatko, Tonks and Purkis, 1994; Gregory, Matatko and Tonks , 1997), Ireland (Hamill, McIlkenny and Watson, 1999) and the USA (Jaffe, 1974; Finnerty, 1976, Givoly and Palmon, 1985; Seyhun, 1986; Lin and Howe, 1990; Jeng, Metrick and Zeckhauser 1999). The seminal paper by Jaffe (1974) provides evidence that insiders‟ purchases (sales) take place after abnormal share price decreases (increases). Thus insiders are able to time their trades. Nunn, Madden and Gombola (1983) hypothesised the existence of an information hierarchy. They find that the performance of trades by chairmen and directors outperforms those made by other corporate insiders such as officers and substantial shareholders. Seyhun (1986) and Lin and Howe (1990) corroborate these findings. Results from studies examining market reaction to directors‟ trades in UK companies provide conflicting evidence (King and Roell,1988; Pope, Morris and Peel, 1990; Gregory, Matatko, Tonks and Purkis, 1994). Gregory, Matatko and Tonks(1997) seek to reconcile the differences in the evidence by using the most comprehensive data set to date. They report that significant abnormal returns can be earned if the appropriate trading strategy, based on the directors‟ trades, is followed. They also emphasise the importance of controlling for size in event studies where cumulative abnormal returns are being investigated over a long post-event window and the proportion of small companies in the sample is high. In using the FTSE 250 companies we hope to avoid the size effect detected by Gregory et al (1997). Whilst significant abnormal returns can be earned, these returns take no account of risk. Modigliani and Modigliani (1997) suggest that the resulting figures from current measures of risk adjusted performance [Sharpe ratio, Sharpe (1966), Jensen‟s alpha, Jensen (1968) and Treynor ratio, Tryenor (1968)] are difficult to interpret. Thus they propose an alternative risk-adjusted performance (RAP) measure. RAP, they suggest, makes the comparison in the performance of any managed portfolio against that of a relevant unmanaged „market‟ portfolio only after properly adjusting the portfolio return for risk. Jeng, Metrick and Zeckhauser (1999) analyse the returns over a one year period to a value- weighted rolling purchase portfolio and a sale portfolio. Their approach, they argue, is free of the statistical difficulties that plague event studies on long-horizon returns. They find that the purchase portfolio only earns abnormal returns and that there is no difference between the abnormal returns to insider trades in small firms and the abnormal returns to insider trades in large firms. McIlkenny and Opong (2000) contend that directors purchase or sell with a longer time horizon in mind than one year. Thus by replicating the trading activities of directors for a five year period, they create a portfolio that captures this time horizon. Their results suggest that an investor can obtain an annual 7.4% return from tracking directors‟ trading activity compared to the FTSE 250 index return of 9.9%. However after adjusting for risk, using the method proposed by Modigliani and Modigliani, the directors‟ portfolio return declines to 4.96%. A major contribution of this study is that it examines directors timing ability which previous studies appear to have overlooked. The focus of previous studies have been on whether directors can earn superior returns from their trading activities. The Timing of Directors‟ Sharedealings and Company Valuation 19 Data The sample of firms in this study comprises those firms that constitute the London Stock Exchange‟s FTSE 250 that have data on directors‟ share dealings from June 1994 to June 1999. Data is available in Extel on directors‟ share dealings from January 1994 which puts a limit on the starting date for the current study. To be included in the final sample, an event has to satisfy two sets of criteria. First, data must be available in Extel and second, price and/or volume data must be available in Datastream/Primark. The first set is used to identify open market transactions by directors (purchase or sale of shares in their own companies) and the second set is used to ensure that the firm‟s weekly share price is available from Datastream. Only open market transactions by directors are used as the proxy for the timing of directors‟ share dealings. All other share transactions by directors are excluded from the study, examples of which include; exercise of options on shares, share bonus entitlement, etc, (see Hamill, McIlkenny and Watson, (1999) for a detailed explanation of their exclusion). A total of 7956 open market transactions by directors took place during the five year period encompassed by this study. Methodology The sample for the study is made up of firms listed on the London Stock Exchange‟s FTSE 250 from June 1994 to June 1999 that have data on directors‟ share dealings during the period mentioned above. Each firm is analysed in two time periods, namely, an estimation period made up of 129 trading days prior to the beginning of the test period. The test period is made up 21 trading days prior to the announcement day and 21 days subsequent to the announcement day Normal daily returns were generated using the standard market model [see Fama (1965)]. The market model is given by: R i,t = + ( R m,t )+ i,t (1) where, εit is the excess returns accruing to shareholders in firm i on day t relative to the day of the announcement of the directors‟ share dealing; Rit is the daily returns to shareholders adjusted for dividends and other capital changes; Rmt is the daily returns on the Financial Times All Share Index; α and β are parameter estimates. The market model parameters in the estimation period are estimated using the 129 daily price observations (from day -150 to day -22) before the announcement of the directors‟ share dealing. Fisher (1966) first pointed out the problems that are caused by asynchronous prices in the calculation of returns. The importance of this problem becomes amplified with a shorter differencing interval and infrequently traded securities. The systematic risk estimated from the market model in (1) is subject to overestimation (underestimation) for frequently (infrequently) traded stocks. The Scholes and Williams (1977) procedure for overcoming the problem of non- synchronous trading regresses the firm return on the contemporaneous, lagged and lead market return, thus producing a contemporaneous 0, j lagged 1 and lead 1 . The beta required for j j equation (3) is then estimated as, 20 Belaire-Franch, Hamill, McIlkenny and Opong / Journal of Accounting and Finance 3 (2004) 15~31 ( 1 0 1) = j j j (2) 1 2 1 where ρ is the autocorrelation coefficient of the market index return. The daily excess returns were computed as: ei,t = Ri,t - ( + ( Rm,t )) (3) where ei,t , Ri,t, α , β and Rm,t are as defined previously. The daily excess returns were averaged across the observations according to 1 N AR t = e (4) N i=1 i,t Daily averages of excess returns are calculated for each of the days from day -21 to day +21 and day +150. These averaged daily excess returns were tested for significance according to ARt t AR = (5) SE it where SEit = [var (ARt)]1/2 with var estimated over the 129 days, -150 to -22. In addition, cumulative average excess returns (CARs) are calculated over various holding periods from day K to L: L CARK,L = ARt (6) t= K where K and L are the beginning and ending day of the holding periods respectively. The significance of CARs are tested using the following [see Rubac (1982), Bonnier and Bruner(1989)]: t CARK,L = CARK,L /S( CARK,L ) (7) where S(CARK,L) = [T( var(ARt)) + 2(T-1)cov(ARt,ARt-1)]2 , with var and cov estimated over the 129 days -150 to -22 and T = L-K + 1. Coutts, Mills and Roberts (1995) provide a robust test of cumulated excess returns in the test period in equation (4). The Coutts et al test (see Appendix A) remedies the deficiencies in the market model and accounts for serial correlation and non- normality in abnormal returns in event studies. A test based on Coutts et al is also conducted. The Timing of Directors‟ Sharedealings and Company Valuation 21 Trading Volume Analysis Due to missing volume data, the number of firms used in the volume analysis totalled 111. The methodology adopted for the analysis of trading volume in the period when directors trade assumes that the volume of shares traded on a particular day equals to the average of shares traded in the estimation period. At the moment, there is no theoretical model available to explain trading volume behaviour. The expected volume of shares traded in a particular day is given by: E (V i,t ) V (7) where Vi,t is the percentage of firm i's shares traded in day t and V is the average of firm i‟s shares traded based on 129 daily observations in the estimation period from day -150 to -22. Abnormal trading volume is therefore given by i,t V i,t V (8) Abnormal volume is estimated over test period days -21 to +150. Significance tests are conducted using the following equation: t t = (9) i,t S where t e = [var ( )]1/2 with var( ) estimated over the 129 days, -150 to -22. In addition, equations (5) and (6) are used to compute cumulative excess trading volume for the test period. Discussion of Results The results of the behaviour of abnormal returns around the period of directors‟ share dealings are reported in Table 1. Column 1 in table 1 indicates the days relative to the purchase or sale of equities by company directors. Column 2 represents directors‟ purchases and column 4 represents directors‟ sales. Columns 3 and 5 represent the t-statistics for the values in columns 2 and 4 respectively. It appears from Table 1 that the price effects of directors‟ purchases is more pronounced than sales. Whereas directors‟ sales are not associated with any significant price activity in the test period examined, a significant positive impact is observed on the day following directors‟ equity purchases. However, all significant values after day +1 are negative. 22 Belaire-Franch, Hamill, McIlkenny and Opong / Journal of Accounting and Finance 3 (2004) 15~31 Table 1. Abnormal Returns Around Directors‟ Equity Dealings Directors‟ Directors‟ Day Purchases t-statistics Sales t-statistic -21 -0.0008 -1.3229 0.0010 1.0300 -20 -0.0008 -1.3520 0.0001 0.0541 -19 0.0000 0.0798 0.0001 0.0724 -18 -0.0007 -1.1253 0.0001 0.1257 -17 0.0000 0.0728 0.0003 0.3173 -16 -0.0006 -0.9474 -0.0000 -0.0397 -15 -0.0004 -0.6005 0.0015 1.5558 -14 -0.0008 -1.3200 0.0016 1.6630 -13 0.0004 0.6675 0.0008 0.7779 -12 -0.0000 -0.0571 0.0012 1.2307 -11 -0.0008 -1.3580 0.0017 1.7869 -10 -0.0014 -2.2666 ** 0.0014 1.3959 -9 0.0011 1.8044 -0.0012 -1.2035 -8 0.0005 0.8278 0.0006 0.6243 -7 -0.0003 -0.5121 0.0009 0.9037 -6 0.0009 1.4474 0.0003 0.2834 -5 -0.0020 -3.2688 0.0014 1.4676 -4 -0.0007 -1.2171 0.0018 1.8638 -3 0.0005 0.7731 0.0004 0.3711 -2 0.0001 0.1860 0.0016 1.6687 -1 0.0001 0.1331 -0.0000 -0.0159 0 0.0006 0.9090 -0.0011 -1.1735 1 0.0019 3.0233** -0.0018 -1.8269 2 -0.0014 -2.2421 -0.0016 -1.6924 3 -0.0000 -0.0392 -0.0016 -1.6631 4 -0.0000 -0.0005 -0.0007 -0.7041 5 0.0002 0.2675 -0.0006 -0.6032 6 0.0002 0.3140 0.0002 0.1621 7 -0.0003 -0.5279 0.0003 0.3214 8 -0.0005 -0.7869 -0.0017 -1.7623 9 0.0000 0.0197 0.0000 0.0382 10 -0.0016 -2.6327 ** 0.0001 0.0565 11 -0.0001 -0.1025 0.0008 0.8066 12 0.0003 0.4293 0.0000 0.0216 13 0.0007 1.0873 -0.0014 -1.4439 14 0.0012 1.9773 -0.0010 -1.0699 15 0.0002 0.2663 -0.0004 -0.3666 16 0.0009 1.4460 -0.0003 -0.2855 17 0.0000 0.0168 -0.0013 -1.3173 18 -0.0004 -0.6548 -0.0015 -1.5633 19 0.0006 1.0173 -0.0005 -0.5487 20 0.0005 0.7529 0.0008 0.7965 21 0.0002 0.3355 0.0004 0.4429 Notes: ** Significant at 0.01 level; * Significant at 0.05 level To test the hypothesis regarding directors‟ timing ability in their dealing activities, we plot the behaviour of cumulative abnormal returns following directors‟ purchase and sales of equities. Figure 1 shows the behaviour of cumulative abnormal returns following directors‟ purchase of equities in their own firms. The graph shows that, on the average, directors purchase when prices appear to be low. Figure 2 shows the behaviour of cumulative abnormal returns in the period around directors‟ sales of equities and this is very revealing. The graph shows that, on the average, directors sell when prices appear to be highest in the test period. The two graphs provide evidence that directors appear to have some timing ability regarding their share dealings. The The Timing of Directors‟ Sharedealings and Company Valuation 23 results support the seminal paper by Jaffe (1974) who provides evidence that insiders‟ purchases (sales) take place after abnormal share price decreases (increases). Tables 2 and 3 provide results of cumulative abnormal returns for various holding periods in the test period examined. The results show that none of the values for the holding periods reported is statistically significant. The test based on Coutts et al (1995) and reported in Tables 2 and 3 support the results based on equations (5) and (6). Table 2. Cumulative Abnormal Returns Around Announcement of Directors‟ Equity Purchases Date Cumulative Cumulative Day t-statistics Abnormal Returns p-value Abnormal Returns (Coutts et al) -21 -17 0.00155 0.4437 -0.00448 0.05729 -16 -12 0.00503 1.4388 -0.00200 0.39970 -11 -7 0.00340 0.9728 -0.00081 0.73507 -6 -3 0.00386 1.2605 -0.00488 0.02017 -2 2 -0.00295 -0.8432 -0.00081 0.73178 -1 1 -0.00292 -1.1401 0.00178 0.16075 0 0 -0.00114 -1.1735 -0.00114 -1.1735 3 7 -0.00241 -0.6897 0.00169 0.23904 8 12 -0.00081 -0.2328 -0.00156 0.50899 13 17 -0.00435 -1.2434 0.00476 0.02264 18 21 -0.00085 -0.2759 0.00155 0.22875 Notes: None of the values is statistically significant; Day is the day relative to the announcement of directors‟ equity purchase/sale Table 3. Cumulative Abnormal Returns Around Announcement of Directors‟ Equity Sales Date Cumulative Cumulative Day t-statistics Abnormal Returns p-value Abnormal Returns (Coutts et al) -21 -17 0.00155 0.4437 0.00516 0.03758 -16 -12 0.00503 1.4388 0.00621 0.01582 -11 -7 0.00340 0.9728 -0.00032 0.91174 -6 -3 0.00386 1.2605 0.00566 0.01275 -2 2 -0.00295 -0.8432 -0.00387 0.19137 -1 1 -0.00292 -1.1401 -0.00320 0.14638 0 0 -0.00114 -1.1735 -0.00114 -1.1735 3 7 -0.00241 -0.6897 -0.00191 0.51093 8 12 -0.00081 -0.2328 -0.00201 0.48645 13 17 -0.00435 -1.2434 -0.00168 0.56176 18 21 -0.00085 -0.2759 -0.00063 0.80545 Notes: None of the values is statistically significant; Day is the day relative to the announcement of directors‟ equity purchase/sale 24 Belaire-Franch, Hamill, McIlkenny and Opong / Journal of Accounting and Finance 3 (2004) 15~31 Table 4. Mean Abnormal Trading Volume Around Directors‟ Equity Dealings Directors‟ Directors‟ Day Purchases Sales -21 -0.052139 0.172593** -20 -0.050155 0.130925** -19 -0.023182 -0.038391 -18 -0.002390 0.032815 -17 -0.024776 0.083712* -16 -0.019944 0.088995* -15 -0.028530 0.015520 -14 -0.025640 -0.021717 -13 -0.021620 0.042441 -12 -0.045296 0.008809 -11 0.001676 -0.019848 -10 -0.029247 -0.046189 -9 -0.053222 0.041487 -8 -0.034844 0.051725 -7 -0.010253 0.058274 -6 0.081895** 0.015511 -5 0.065156* -0.003118 -4 -0.031085 0.242107** -3 -0.008935 0.099894** -2 0.024315 0.026313 -1 0.172661** 0.486997** 0 0.023234 0.128562** 1 0.042299 0.037790 2 0.023481 -0.030506 3 -0.021178 0.005597 4 -0.001896 -0.008874 5 -0.014375 -0.008235 6 -0.004737 -0.017876 7 0.004499 0.034528 8 -0.030691 -0.005214 9 0.001413 0.052122 10 -0.047573 0.001174 11 -0.009552 -0.002310 12 -0.017140 0.032794 13 0.029082 0.006398 14 -0.041964 0.007505 15 0.035582 -0.029083 16 -0.028833 0.044153 17 0.075392** 0.003277 18 -0.044701 -0.004792 19 -0.042931 0.006977 20 -0.038804 -0.061639 21 -0.029332 0.060038 Notes: ** Significant at 0.01 level; * Significant at 0.05 level The Timing of Directors‟ Sharedealings and Company Valuation 25 Days Relative to Directors Equity Sales Figure 1. Cumulative Abnormal Returns for Directors‟ Equity Purchases Days Relative to Announcement of Equity Sales Figure 2. Cumulative Abnormal Returns for Directors sales 26 Belaire-Franch, Hamill, McIlkenny and Opong / Journal of Accounting and Finance 3 (2004) 15~31 Days Relative to Equity Purchase Figure 3. Mean Abnormal Trading Volume Around Directors‟ Equity Purchase Date Days Relative to Directors‟ Equity Purchase Figure 4. Cumulative Abnormal Trading Volume Around Directors‟ Equity Purchase Date The Timing of Directors‟ Sharedealings and Company Valuation 27 Days Relative to Directors‟ Equity Sales Figure 5. Abnormal Trading Volume Around Directors‟ Equity Sales Date Days Relative to Directors‟ Equity Sales Figure 6. Cumulative Abnormal Trading Volume Around Directors‟ Equity Sales Date 28 Belaire-Franch, Hamill, McIlkenny and Opong / Journal of Accounting and Finance 3 (2004) 15~31 The results of the behaviour of trading volume are reported in Table 4 and Figures 3 –6. Table 4 indicates that significant above average trading takes place on the day prior to directors‟ equity purchases. For directors‟ equity sales, significant above average trading takes place in the equity of those firms on the day prior to the sale as well as on the day that directors sell equities in their firms. A plot of abnormal trading volume is reported in Figures 3 and 5 for directors‟ purchases and sales respectively. The plot clearly shows that abnormal trading volume is highest on the day prior to and the day that directors‟ purchase or sales take place. If the liquidity hypothesis is valid for directors‟ equity dealings, there should be an immediate increase in trading volume following the periods. While the results support the view that directors possess some timing ability in their share dealing activities, it is not clear from this study that mimicking what company directors do could be profitable since no significant positive abnormal returns are earned following directors‟ share dealings announcements. Conclusions Directors are assumed to have more information about their company‟s prospects than any other market participant. Thus it would appear that directors are well placed to profit from insider trading. This suggests, therefore, that company directors may time their dealing activities to coincide with periods which will be most profitable to them. Directors will therefore buy when they perceive the firm‟s share price to be undervalued and sell when the price is overvalued. This study seeks to provide evidence on the ability of company directors to time their purchasing (selling) activities to coincide with periods when they perceive the value of their firms as relatively low (high) compared to their valuation on the basis of their superior information. In the presence of strong form market efficiency, the timing ability of directors share dealings will be redundant. The sample comprises those firms that constitute the FTSE 250. Whilst not conclusive, the results of the study appear to indicate that directors do have some timing ability in their share dealings. It appears that directors share purchases (sales) usually follow abnormal share price decreases (increases). However, no significant positive abnormal returns are earned following directors‟ share dealing announcements. The Timing of Directors‟ Sharedealings and Company Valuation 29 References Bonnier, K. and Bruner, R.F. 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Sharpe, W.F., (1966), Mutual Fund Performance, Journal of Business, Supplement on Security Prices, 39. Tryenor , J.L., (1968), How to Rate Management Investment Funds, Harvard Business Review, 43. 30 Belaire-Franch, Hamill, McIlkenny and Opong / Journal of Accounting and Finance 3 (2004) 15~31 Appendix A A.1. ZD – test Coutts, Mills and Roberts (1995) provide an alternative specification to Patell's methodology, which they demonstrate does not have the correct standard error. However, errata in Coutts et al's methodology makes it difficult to replicate their ZD test. The methodology presented here remedies these errors. Figure below outlines the notation used for the estimation and event period, primarily for the purposes of pedagogy. Time 1 T T+1 e T+m Estimation period Event Period We have the single index market model written in vector form as: y it xit i u it ( A.1.1) where xit = (1, xit ) and i = ( i , i) or, in matrix form as yi Xi i ui (A.1.2) where yi yi1,......... yiT , .., ui u i1,......, iT , and u 1,......., Xi xi1,......,xiT 1 xi1,.....,xiT The estimated model is used to forecast m future observations yi * ( yi,T 1,...,yi,T m) using the matrix of future observations; i, xi, Xi * x*T 1,......, *T m 1 1,......, xi,T 1,......,xi,T m and the OLS estimator i Xi Xi 1 Xi y i . ˆ The vector of prediction errors is then ui * (u i,T 1,......,ˆ i,T m), obtained from: ˆ u ˆ ui * y i* X i * i (A.1.3) where yi * is the return on the firm over the test period, X i * is a typical m 2 OLS matrix of ˆ market returns over the test period and i is the vector of OLS estimated parameters. The cumulative sum of forecast errors over the event window (T+m1, T+m2) is: The Timing of Directors‟ Sharedealings and Company Valuation 31 T m2 u i Cui* ˆ (A.1.4) T m1 where 'C' is an appropriately designed 1 n selection vector, as opposed to a m × 1 selection ˆ factor in the original article, which has the elements taking the value unity if ui is contained in the event window and zero if it is not. The covariance matrix is given by: Di Xi Xi T 1Qi Xi Xi T 1 ( A.1.5) where Qi is an estimate of E Xi ui ui Xi T which can be approximated by: T p T ˆ 1 1 Qi T x it xit u it T ˆ2 xit xi,t s xi,t s xit u it u i,t s ˆ ˆ (A.1.6) t 1 s 1 t s 1 for p chosen to be approximately T 1/ 3 ; p should be increased until the truncations become ˆ trivial. Qi is thus an estimate of the average of the variances of xit uit plus a term that takes into account the covariances between xit uit and xi,t s ui,t s , the number of covariances being truncated at s=p through the assumption of mixing (see, Mills, 1993, Chapter 5). In these circumstances we have: E Cui * u i * C i CC CXi * Di Xi * C / T V D i 2 (A.1.7) and using this expression, an adjusted statistic Z D N CAR m1, m 2 V D1 / 2 ~ N (0,1) , where V D i 1V D i N . Equation A.1.7 does not include an erroneous X term, which is in the original formula for V D i in Coutts et al.
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