Information Leakage and Opportunistic Behavior Before Analyst Recommendations: An Analysis of the Quoting Behavior of Nasdaq Market Makers

Abstract

This study investigates analysts' potential conflicts of interest due to the relationship between research and trading departments within the same brokerage firm. We find evidence consistent with the presence of information leakage and opportunistic behavior before analysts revise their recommendations for Nasdaq-listed stocks. We examine the quoting behavior of market makers who are affiliated with the same brokerage house as the recommending analysts (recommending market makers). In the hour and a half (three hours) before upgrades (downgrades), the proportion of time that the recommending market makers quote at the inside bid (ask) increases significantly, by up to 43% (59%), whereas their quoting behavior at the ask (bid) does not change. This pattern in the quoting behavior of recommending market makers anticipates the direction of the pending recommendations and is highly significant, even after controlling for their own behavior in non-announcement periods and for the quoting behavior of other market makers. Further, starting more than two hours before the public announcements, we document substantial price reactions that anticipate the direction of the pending recommendation revisions. More importantly, the quoting behavior of recommending market makers has explanatory power for stock returns immediately preceding the public announcements. These findings are consistent with non-public information being impounded into stock prices as a result of opportunistic behavior by recommending market makers or by investors who trade through recommending market makers.