Idiosyncratic Risk and Corporate Transactions

Abstract

It has been documented that insiders trade when they perceive their firms are mispriced and when they hold private information about future cash flows. Based on these findings, we test whether insiders at firms with high-idiosyncratic risk (which is associated both with financial anomalies and with greater private information in prices) earn higher returns to their trades than insiders at firms with lower idiosyncratic risk. We document that, indeed, the profitability of corporate transactions (insider purchases and sales, and share repurchases) increases dramatically with idiosyncratic risk. Corporate transactions are contrarian and the magnitudes of returns prior to and following trades increase with idiosyncratic risk. In further analyses, we find little evidence that these patterns relate to private information: they are not explained by common proxies for future cash-flow news and are not mitigated by increased regulatory oversight of insider trading since mid-1990s. Conversely, we document evidence indicating that high-idiosyncratic risk stocks are priced less efficiently: institutional investors are slow to respond to corporate transactions and prices following trades drift for several months.