A Theory of Insider Purchases

Abstract

Although prior work indicates that insider purchases signal undervaluation, there is scant evidence about what specific information such purchases convey, or what determines the extent of the undervaluation. Our theory explains the nature of the information conveyed by insider purchases, their incidence, and their signaling value. We argue that, conditional on information asymmetry, open market purchases occur when they plausibly signal that risk averse, undiversified insiders are willing to bear incremental wealth risk. Our tests account for limits to the public observability of insiders’ wealth and show, consistent with our predictions, that insider purchases are more frequent and informative in higher-risk contexts which we define, alternatively, as firms with higher fundamental risk (e.g., small, high book-to-market, high volatility firms), firms experiencing riskier circumstances (e.g., poor financial and market performance, low reporting credibility), and firms where insiders’ are exposed to higher risk as a result of their compensation contracts and ownership (e.g., option and share holdings, employment horizon). Further, exploiting our prediction that the signaling value of purchases depends on the increase in the insider’s wealth risk that is inferred by investors, we show that strategies based on linear combinations of the high-risk facets of these factors magnify the abnormal returns to strategies mimicking insider purchases by a factor of two to three. Finally, our results are robust to considering opportunistic/routine partitions of the sample, suggesting that insider purchases are largely strategic.