Liquidity Changes Associated with Open Market Repurchases

Abstract

Before the tax-law changes of 1986, common stock repurchases received favorable tax treatment relative to cash dividends, yet more than 80% of the New York Stock Exchange-listed firms did not use repurchases for distributing value to their stockholders. Prior research suggests a possible resolution of the puzzle by examining the effect of open market repurchases on the liquidity of the firms' stocks. The liquidity of the stock as measured by bid-ask spread may be affected by stock repurchases in any one or all of the following ways. First, when management undertakes to reacquire the firm's shares in the open market they are, in effect, competing with the market makers of the stock. This open market repurchase activity, in the absence of information asymmetry, should result in greater liquidity or lower bid-ask spread. Second, a direct consequence of open market repurchase announcements may be increased trading in the secondary market. Increased trading volume makes it easier for the market maker to reverse his position in the stock. Therefore, the inventory holding cost component of bid-ask spread should decline upon announcements of open market repurchases. A decline in the bid-ask spread would be consistent with this explanation. Third, prior research suggests that open market repurchase announcements are associated with increased trading by informed traders in the secondary market for the firm's stock. Informed traders trade with market makers only at favorable prices. Hence, the adverse selection component of the bid-ask spread should increase in the post-announcement period. This information-asymmetry- based explanation predicts increased bid-ask spreads following announcements of open market repurchases. However, it should be noted that an asymmetric-information-based explanation does not necessarily imply that other market participants face the informed traders in all trades at all times. Specifically, the likelihood of trading with an informed trader is greater when stock prices are lower rather than higher. Also, repurchases only involve buying and not selling by informed traders. Hence, the risk of trading against the informed trader is much less.