Download Stock Price Levels and Price Informativeness

Stock Price Levels and Price Informativeness
Konan Chan
National Chengchi University
Tse-Chun Lin
University of Hong Kong
Fengfei Li
University of Hong Kong
Ji-Chai Lin
Louisiana State University
For Presentation at NTU conference
December 7th, 2012
What we are interested in knowing…
2

Does stock price level matter in where informed
investors choose to trade?

In other words, would high stock price level lead to lower
informed trades in the equity market and make the options
market a more appealing trading venue to the informed?

Is this venue switching behavior among the informed more
prominent for stocks with more difficulty to attract small
investors.

Ultimately, since informed trading carries information, we
would like to investigate whether stock price levels affect
price informativeness.
Intuition: High stock price level and informed
trading
3

Uninformed trading is necessary for market making (Kyle, 1985)

Facing budget constraints and limited risk-sharing capacity,
uninformed individual investors are likely excluded from
participating in trading high-price stocks

When informed traders cannot effectively camouflage their
trades among uninformed trades, they cannot gain much from
their private information

This would reduce their incentives to collect information and
trade such that the informational role of stock price could
diminish.
Examples of budget constraints on small
investors
4

When companies in Japan reduce the number of shares in a
round lot, the number of their individual shareholders
significantly increases


When mutual funds split their shares, they experience
significant increases in net assets and shareholders


Fernando, Krishnamurthy, and Spindt (1999)
Small trades increase following the splits


Amihud, Mendeslon, and Uno (1999)
Schultz (2000)
Stock splits attract more uninformed and informed trades

Easley, O’Hara and Saar (2001)
Our Objectives
5

We employ the O/S, relative trading volume of options
over stock in Roll, Schwartz, and Subrahmanyam (2010),
to

Illustrate how does stock price level affect the choice of trading
venues by the informed traders.

Help to explain why firms split their stocks.

Shed some light on the nominal share price puzzle.
Easley, O’Hara, and Srinivas (1998)
multi-market sequential trade model
6

Informed traders move across options market and equity market
to maximize trading profits.

The model suggests that more informed trading in options
market when



Decreasing the depth of the stock market
Increasing the depth of the options market
In their model, the market depth is determined by the number of
uninformed trades in each market.
Why is O/S a useful tool for our objectives?
7

Following Roll et al. (2010), we use O/S to track where
informed traders prefer to trade, the options market or the
equity market.

If high price causes the depth of the equity market to decrease,
then O/S should rise to reflect an increase in traders’
preference to trade listed options.

Conversely, if a stock split is an effective way to attract
uninformed traders and increase the depth of the equity
market, then O/S should fall after the split.
Hypothesis 1 and its predictions:
8


H1: High stock price level would

impede informed trading on the stock and

make listed options more appealing to the informed
Predictions:

O/S increases with stock price level.

The positive relation between O/S and stock price level is
stronger for firms that have more difficulty in attracting small
investors.

High stock price level decreases stock price informativeness.
Hypothesis 2 and its predictions:
9

For high-priced stocks, managers can use stock splits to
attract more uninformed traders to improve informed
trading and enhance informational efficiency of stock
prices.

Predictions:
O/S rises before stock splits.
 Pre-split O/S is informative about the firms’ future prospects.
 O/S declines after splits.
 Stock price becomes more informative after stock splits.
 Post-split O/S contains less information, compared with presplit O/S.

Why do we care about price informativeness?
10

It could improve corporate resource allocation.



The risk of investing in the stock is lower when stock
price reflects more information.


Khanna, Slezak, and Bradley (1994)
Subrahmanyam and Titman (2001)
Roll, Schwartz, and Subrahmanyam (2009)
We follow Gelb and Zarowin’s (2002) specification for price
informativeness: regressing current returns against (current
and) future earnings changes.
Data for testing H1
11

H1 posits that high stock price level may



impede informed trading on the stock and
make listed options more appealing to the informed.
To test this hypothesis, we use a comprehensive sample of

firms with trading data available on both




listed option (from OptionMetrics) and
the underlying stock (from CRSP).
Sample period:1996 to 2010.
The number of firms in a given year varies over time,


ranging from 960 in 1996 to 1967 in 2007,
with a total of 4702 firms.
Key variables
12

Following Roll e al. (2010), we use two measures of O/S:



ShO/S based on daily share volume and
$O/S based on daily dollar volume.
The two key variables for testing H1 are


Price, the log stock price level, and
Price x Small,

where Small is a dummy variable equal to one if the dollar ownership
per shareholder (market cap/number of ordinary shareholder) is greater
than the cross-sectional median, and zero otherwise.

We assume that firms with Small=1 have more difficulty in attracting
small investors than those with Small=0. If a firm can easily attract small
investors, it would have many small investors as shareholders and the
dollar ownership per shareholder would be relatively small.
Table 2. Regressions of O/S on Share Price
13
Table 3. Price Informativeness
(Gelb and Zarowin‘s (2002) specification) – full sample
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Model
ERC (Et)
Future ERC (Et+)
Future return (Rt+)
Earnings-price ratio (E/P)
Asset growth (AG)
Size
1
0.018***
(3.58)
0.082***
(5.54)
-0.073***
(-19.03)
0.001***
(8.63)
0.304***
(16.35)
-0.101***
(-25.15)
Price (P)
2
0.012**
(2.41)
0.246***
(9.71)
-0.065***
(-17.51)
0.002***
(14.26)
0.252***
(13.87)
-0.183***
(-35.71)
0.230***
(27.30)
ERC x Price
Future ERC x Price
-0.067***
(-9.43)
Future return x Price
Earnings-price ratio x Price
Asset growth x Price
Size x Price
Intercept
Year fixed effect
Adj-R2 (%)
N
0.690***
(21.68)
Yes
16.59
30306
0.770***
(22.03)
Yes
21.01
30306
3
-0.009
(-0.65)
0.197***
(7.52)
-0.121***
(-13.21)
0.004***
(9.78)
0.255***
(4.53)
-0.376***
(-28.45)
-0.144***
(-5.71)
0.009
(1.47)
-0.052***
(-7.29)
0.022***
(6.10)
-0.001***
(-6.54)
-0.002
(-0.11)
0.063***
(16.84)
1.861***
(22.18)
Yes
23.07
30306
Data for testing H2
15

H2 posits that, for firms whose high stock price levels hinder
uninformed traders to enter the market, managers can use
stock splits to attract more uninformed traders to


Improve informed trading and
Enhance informational efficiency of stock prices.

We test H2 using a sample of splitting firms with listed
options.

Our split sample includes 1,687 splits, which have a split
factor of at least 0.25, over the period of 1996 through 2010.
Table 5. Cross-sectional Regressions of Pre-split
O/S on Pre-split Share Price for Splitting Stocks
16
Figure 1. Pre-Split and Post-Split O/S of Split
Firms vs. Benchmark Firms
17
Table 6. Changes in O/S Before and After Splits
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Table 7. Cross-Sectional Regressions of Split CARs
on O/S
19
Table 8. Regressions of SUE on O/S
20
Pre-split O/S can also predict earnings surprises from one quarter to four quarters
after the stock splits, suggesting that option traders prior to stock splits are informed
about future earnings surprises.
Table 9. Long-Run Returns Sorted by O/S
21
 The abnormal returns on the calendar-time portfolios from all three
models increase monotonically with pre-split O/S.
 The results suggest that option traders prior to stock splits are also
informed about split firms‘ future stock performance.
Table 10 Price Informativeness Before and After
Splits (Gelb and Zarowin‘s (2002) specification)
22
Table 11. Predictability of O/S on SUE and Earnings
Announcement Returns around Splits
23
Conclusion
24

The objectives of our paper are to




To achieves the objectives, we propose two hypotheses:



Illustrate how does stock price level affect the choice of trading
venues by the informed traders.
Explain why firms split their stocks.
Shed light on the nominal share price puzzle.
H1 posits that high stock price level impedes informed trading on
the stock and reduce the price informativeness about future
earnings.
H2 posits that firms can use stock splits to improve informed trading
and make their stock price more informative.
We find evidence consistent with our hypotheses.
Contributions
25

We extend Roll et al. (2010) to show that


stock price level also plays a role in where informed traders
choose to trade.
We also add to the literature on stock splits by
showing that

stock price level affects the informativeness of stock price
26
Thank You
Table 1. Summary Statistics
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Table 1. Correlations
28
Table 4. Summary Statistics of Stock Splits
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Table 4. Correlations
30