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Detecting informed trading prior to hospitality acquisitions
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Hospitality Management 25 (2006) 570–585 www.elsevier.com/locate/ijhosman
Detecting informed trading prior to hospitality acquisitions Seonghee Oaka,, William Andrewb a
Hospitality and Tourism Administration, School of Business, North Carolina Central University, P.O. Box 19716, Durham, NC 27707, USA b School of Hospitality Management, Pennsylvania State University, 201 Mateer University Park, PA 16802, USA
Abstract Hospitality acquisition payment announcements provide a particularly interesting opportunity for exploring the effects of information asymmetry on informed trading activities in hospitality firms. The empirical results in this paper, derived from a market microstructure approach, support the presence of informed trading in the short term prior to a hospitality acquisition. For cash- or stock-financed acquisitions, while we detect no change in the bid–ask spread of acquiring firms prior to an acquisition announcement, the ask or bid depths narrow prior to an acquisition payment announcement. For mixed-financed acquisitions, the bid–ask spread for acquiring firms widens and the ask depth narrows prior to the acquisition payment announcement. r 2005 Elsevier Ltd. All rights reserved. Keywords: Information asymmetry; Bid–ask spread; Depth; Acquisition
1. Introduction This study examines the effect of information asymmetry on informed trading activities related to the acquisition of hospitality firms. Because it is typical in hospitality corporations for ownership and management to be separate, corporate Corresponding author. Tel.: +1 919 530 6239; fax: +1 919 530 7865.
E-mail addresses: [email protected] (S. Oak), [email protected] (W. Andrew). 0278-4319/$ - see front matter r 2005 Elsevier Ltd. All rights reserved. doi:10.1016/j.ijhm.2005.04.005
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managers may acquire private information that outsiders, including stockholders, lack. Hospitality corporate acquisitions provide one situation where information asymmetry can occur. Managers of acquiring firms may base the type of payment they make to the target firm on their perception of the economic value of their own firm. When managers of acquiring firms perceive the shares of their own firms to be overvalued, they may use those shares to pay for the acquisition. When the managers of acquiring firms perceive their shares to be undervalued, they may avoid using those shares and instead pay for the acquisition in cash. When managers of acquiring firms perceive their shares to be fairly valued with all other factors being equal, they will be indifferent to using stock or cash and thus may use a mix of stock and cash as payment. In addition, when hospitality managers perceive their firm to be under- or overvalued, they may personally buy or sell their firm’s shares. In the case of an acquisition, when managers of hospitality acquiring firms perceive their shares to be overvalued and thus use those shares to purchase the target firm, they may sell their shares before the acquisition payment announcement. When managers of hospitality acquiring firms perceive their shares to be undervalued and use cash instead of stock for the acquisition, they may buy shares of their firm before the acquisition payment announcement. When managers of hospitality acquiring firms perceive their shares to be valued fairly and choose a mix of stock and cash to purchase the acquisition, they may be indifferent to buying or selling their shares on their personal account before the acquisition payment announcement. In addition to managers, other informed traders may undertake transactions with their personal accounts prior to hospitality acquisition payment announcements. These informed traders are categorized by the methods they use to estimate fundamental value into value traders (a category that includes managers), technical traders, and arbitrageurs. Value traders (including managers) estimate the fundamental value of a security using all the information available to them and an appropriate economic model. They then base their trading decisions on the fundamental value as compared to the market price of the security. Technical traders identify historical price patterns inconsistent with prices that fully reflect fundamental values. Arbitrageurs estimate relative differences in fundamental values. When informed traders compare their value estimates of an acquiring firm’s shares with the corresponding market price of the shares, they tend to buy shares or share derivatives they believe to be undervalued and sell shares or share derivatives they believe to be overvalued. The behavior of these informed traders may affect such security trading practices as the bid–ask spread and the bid and ask depth. This trading process is known as the market microstructure. This study measures informed trading using a market microstructure approach in the time period 25 days before and 25 days after the acquisition payment announcement. The short-term market microstructure analysis captures informed traders’ transactions attributable to information leakage close to the acquisition payment announcement. Hospitality acquisition payment announcements provide a particularly interesting opportunity to explore evidence of informed traders taking advantage of private
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information for their personal benefit as hospitality firms reflect a fairly unique set of firms, especially in respect to manufacturing firms. One can infer informed trading actions from changes in the bid–ask spread and depth around the hospitality acquisition payment announcement. In the short term, informed traders with private information may influence the bid–ask spread and the depth, which is set by market makers. If market makers notice informed trades in the market, they will widen the bid–ask spread and narrow the bid or the ask depth. This study is important since no previous hospitality research has addressed the process of informed trading around hospitality corporate events despite the importance of information asymmetry in the financial markets. Previous studies of hospitality acquisitions only focused on the stock market reaction through event studies (Canina, 2001; Sheel and Nagpal, 2000; Kwansa, 1994). In addition, these studies of hospitality acquisitions typically focused on acquisitions occurring during a limited time period. Since this study examines all acquisitions in the hospitality industry between 1983 and 1999, it presents a comprehensive picture of hospitality acquisition activities. This study also represents the first formal empirical research to use the market microstructure method in hospitality finance. If information asymmetry exists in a hospitality acquisition, this study should demonstrate whether informed trading influences the process of price adjustment in the market microstructure.
2. Literature review 2.1. Information asymmetry theory Financial analysts tend to explain market price by reference to complete information, where buyers and sellers have an equal knowledge of the quality of goods (Varian, 1996). This equality occurs when market participants can easily obtain information without spending a great deal of time and money on an information search. Easily accessible information results in market prices quickly reflecting differences in the quality of various goods. But in the real world, acquiring a complete body of information can be expensive. In the real world, information may be ‘‘asymmetrical,’’ and one can categorize market participants as either informed or uninformed. Those with relevant private information are among the informed. When informed traders trade securities with uninformed traders, they can adversely affect the interests of the uninformed in the market. This situation is called an ‘‘adverse selection problem,’’ which appears familiarly in the used car business. In the case of an acquisition announcement, managers and other informed traders tend to be informed and market makers tend to be uninformed. These informed traders can adversely affect market makers and outside investors by engaging in insider trading. In the used-car market, a seller tends to have better information about the quality of a car than a prospective buyer does (Akerlof, 1970). Even though the owner of a new car may have driven it only a few kilometers and the car, now used, remains in perfect condition, a subsequent buyer cannot readily distinguish it from a so-called
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‘‘lemon.’’ Since lemons tend to drive out good cars in the used car market, the average quality there tends to be lower relative to the average price. Similarly, with hospitality acquisition announcements, outside investors and market makers rarely know if good or poor prospects exist for the combined firms, but managers in acquiring firms may have this information. In the case that hospitality managers perceive poor prospects for their firms, the managers and other informed traders can use their private information to sell their firms’ shares on their personal account and this trading can lessen the market value of their firms for outside investors and adversely affect market makers in the stock. 2.2. Market microstructure French and Roll (1986) studied the impact of private information on the financial markets, and they indicated that most return volatility in stock markets is caused by public information that arrives during normal business hours and by private information that affects prices through informed trading. French and Roll showed return variances for weekday exchange trading hours to be higher than for weekends and holidays. This result implies that informed investors are more likely to trade when the exchanges are open. Low daily variance ratios relate strongly to exchange holidays because private information can affect prices only through informed trading; in this case, the price reaction is delayed until informed trading occurs. In the study reported here, the use of the market microstructure approach around hospitality acquisition payment announcements focuses on the arrival of private information from informed trading prior to the acquisition of the public information during normal trading hours. No previous studies, either in hospitality or in general finance, have examined the impact of different payment types for an acquisition on market microstructure trading. As such, the study presented here breaks new ground in both the general finance and the hospitality finance literature. In the trading process of the market microstructure, market makers, who function as match makers between buyers and sellers, play an important role. Demsetz (1968) concluded that market makers take responsibility for an immediate exchange of titles to securities and they control the bid–ask spread so as to maximize their own profits and minimize their own losses. They match buy and sell orders and hold an inventory of securities used to fill unmatched orders. Market makers make a profit from the ‘‘spread,’’ the difference between the buying (ask) and selling (bid) price per share. The bid–ask spread is a function of several variables including trading volume, the market maker’s inventory, competition, and asymmetric information among informed investors and the market maker (Madhavan, 2000). In addition, Clarke et al. (2004) report that the degree of firm’s diversification causes bid–ask spread changes. An informed trader makes profits by trading with a market maker who is unaware of the firm specific information the informed trader possesses. Since informed trading increases a market maker’s costs, it also affects the bid–ask spread (Bagehot, 1971). In addition to informed traders, market makers also deal with liquidity traders, who convert securities into cash and have no special information. As Kyle (1985) first suggested, a dynamic model with sequential auctions includes two steps
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for insider trading: (1) the insider and the liquidity traders simultaneously choose the quantities they will trade; and (2) the market maker sets a price and trades the quantity that clears the market. Kyle discussed the constant volatility that information incorporates into prices. In his model, all of the insider’s private information is incorporated into prices by the end of trading. Thus, around acquisition payment announcements, one would expect information asymmetry eventually to disappear and the market price to reflect the impact of managerial private information. Market makers cannot distinguish between informed traders and liquidity traders. But when they detect unusual changes in prices or volume, they widen the bid–ask spread to prevent losses against informed traders and to gain protection against liquidity traders (Bagehot, 1971). When market makers detect unusual buying, they raise the ask price to discourage further purchases. When they detect unusual selling, they lower the bid price to discourage further sales (Harris, 2003). Hence, the bid–ask spreads should become wider prior to hospitality acquisitions using stock and cash financing. Likewise, the bid–ask spreads would not be expected to change prior to hospitality acquisitions using mixed financing. Information-based microstructure models have been used to explain bid–ask spread changes under information asymmetry. In 1985, Glosten and Milgrom reported that the bid–ask spread increased when buy (sell) orders forced market makers to revise their expectations of the stock value upward (downward) and forced their quotes to move accordingly. Since the study reported here focuses on the existence of private information around hospitality acquisition payment announcements, it examines changes in bid–ask spreads caused potentially by information asymmetry. One normally uses a short period, 25 days before and 25 days after the acquisition payment announcement, to measure the market microstructure process (Ahn et al., 2001). Changes in market depth provide yet another way of detecting informed traders. But the role of quoted depth has received little research attention. Dupont (2000) suggested that depth is more sensitive than the bid–ask spread to a change in the quality of the informed traders’ information. Kavajecz (1999) offered theoretical support that spreads will widen and depths will fall in response to an increase of information asymmetry between informed traders and market makers. On the NYSE, a complete quote includes the best price available for purchase (the ask) and sale (the bid), as well as the number of shares available at each price (the depth) (Lee et al., 1993). When market makers detect unusual buying, they lower the ask depth to discourage further purchases. When market makers detect unusual selling, they lower the bid depth to discourage further sales (Harris, 2003). Chung et al. (1995) provided additional evidence on the market maker’s involvement in the market microstructure. Since the market maker controlling the bid–ask spread under information asymmetry can be observed, financial analysts utilize the market maker’s behavior to find a stock with a greater extent of information asymmetry due to the higher value of private information. Given an increasing probability of informed traders, market makers may respond with a narrower ask depth prior to hospitality acquisitions using cash financing and a narrower bid depth prior to
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hospitality acquisitions using stock financing. There should be no change of depth prior to hospitality acquisitions using mixed financing. The presence of information asymmetry can influence market prices adversely. Although regulations relating to insider trading exist to protect uninformed investors against informed investors, they do not always prevent insider trading. Hence, the existence of private information still presents opportunities for insider and informed traders to benefit disproportionately. Previous studies confirm active insider trading over periods prior to corporate information events—for example, increased insider selling and decreased insider buying before corporate seasoned equity issues. Although informed trading is difficult to detect, a market microstructure approach in the short term can help identify information asymmetry prior to a hospitality acquisition payment announcement by detecting changes in the bid–ask spread and bid or ask depth before and after the acquisition payment announcement date. 2.3. Research hypotheses Bid–ask spread hypotheses are expressed as the following. ASpre is the average spread in the pre-event period 25 days before the hospitality acquisition payment announcement and ASpost is the average spread in the post-event period 25 days after the hospitality acquisition payment announcement. For hospitality acquiring firms using cash financing Ho1 : ASpre pASpost ; Ha1 : ASpre 4ASpost : For hospitality acquiring firms using stock financing Ho2 : ASpre pASpost ; Ha2 : ASpre 4ASpost . For hospitality acquiring firms using mixed financing Ho3 : ASpre pASpost ; Ha3 : ASpre 4ASpost . Depth hypotheses are expressed as the following. AADpre is the average ask depth in the pre-event period and AADpost is the average ask depth in the post-event period. Also, ABDpre is the average bid depth in the pre-event period and ABDpost is the average bid depth in the post-event period. For hospitality acquiring firms using cash financing Ho4 : AADpre XAADpost ; Ha4 : AADpre oAADpost . For hospitality acquiring firms using stock financing Ha5 : ABDpre XABDpost ; Ho5 : ABDpre oABDpost . For hospitality acquiring firms using mixed financing Ho6 : AADpre XAADpost ; Ha6 : AADpre oAADpost , Ho7 : ABDpre XABDpost ; Ha7 : ABDpre oABDpost .
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3. Data 3.1. The sample of hospitality firms making acquisitions The authors searched the Center for Research in Security Prices (CRSP) tapes for all NYSE, AMEX, and Nasdaq hospitality firms delisted during 1983–1999 (SIC industry codes: hotel 7011, restaurant 5812, casino 7999, and cruise 4481). This study examined hospitality acquisitions only after 1983, because data for analyzing the market microstructure are available only after that year. The CRSP tapes define firms delisted because of acquisition with delisting codes between 200 and 203. After identifying the delisted firms (targets), the authors consulted the Wall Street Journal Index to determine the acquiring firms. Trade magazines like Hotel & Motel Management and National Restaurant News provided additional deals unrecorded among the delisted firms in the CRSP tapes. In addition to these sources, the Mergerstat Review and the Merger Yearbook served to identify acquisitions in the hospitality industry. The search produced a total of 111 acquisitions, which represent the entire public population of acquisitions in the hospitality industry between 1983 and 1999. The authors divided their sample of hospitality acquiring firms into three subsets based on the acquisition payment type (cash, stock and mixed) in the announcement as reported in the Dow Jones News Service (DJNS). If the payment type for the observation was unknown, the acquisition was excluded from this study, which reduced the 111 announcements to 81. The first subset of observations is the stock-payment group where only the acquirer’s common stock was used to pay for an acquisition (35 of the 81 observations). The second subset of observations is the cash-payment group where only cash was used to pay for an acquisition (20 of the 81 observations). The last subset of observations is the mixed-payment group in which both cash and stock were used to pay for an acquisition (26 of the 81 observations). 3.2. Microstructure data In order to test the bid–ask spread and depth hypotheses, the authors drew data from the Trade and Quote (TAQ) database, which contains all the trades and quotes for stocks listed on the NYSE, the AMEX and Nasdaq’s National Market System (NMS). Since the TAQ data were available only after 1993, the authors used Institute for the Study of Security Markets (ISSM) transaction data files, which contain trades and quotes, for the period from 1983 to 1992. From a total sample of 81 collected hospitality acquisitions, 75 observations proved to be suitable for the market microstructure study. Six observations were dropped because of the lack of historical trades and quotes in either the ISSM or TAQ data. Throughout this study, the market microstructure test period is divided into three periods: pre-event, event and post-event (Ahn et al., 2001). The event day is defined as the first day on the DJNS when the firm announced the acquisition
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payment type (three acquisition payment announcements did have prior acquisition announcements). The event period consists of 3 days, which is from 1 trading day prior to the acquisition payment announcement to 1 trading day subsequent to the announcement. The pre-event period ran from 25 trading days to 2 trading days prior to the acquisition payment announcement day. The post-event period ran from 2 trading days to 25 trading days subsequent to the acquisition payment announcement day. Previous studies imply a positive relationship between information leakage and stock price run-up 3 weeks prior to acquisition announcements (notably Keown and Pinkerton, 1981; Ahn et al., 2001). Accordingly, this study used 25 trading days before and after the acquisition payment announcement date as its cutoff dates. A series of filters served to clean the trade and quote data used for the market microstructure analysis. Nonstandard delivery trades and all quotes that were not Best Bid and Offer (BBO) eligible were discarded (Ahn et al., 2001). BBO-ineligible quotes include closing quotations, trading halts, pre-opening indications, and nonfirm quotations. All trades and quotes that were time-stamped before 9:30 a.m. EST (market opening) or after 4:00 p.m. EST (market closing) were also discarded. Pre-opening transactions were excluded from the sample because they were conducted in a call market, while transactions after the opening were generally conducted in a continuous auction market (Lin et al., 1995; Huang and Stoll, 1997). Quotes were also excluded if they originated from markets other than the primary exchange where the stock was listed. For the announcement time, the Dow Jones News Service (DJNS) database provided day and time stamps to the minute. If the announcement of an offer came after 4:00 p.m. EST, the next trading day became the announcement date (Ahn et al., 2001).
4. Methodology 4.1. Quoted spread To calculate the quoted spread, one needs the ask and bid price for 25 days before and 25 days after acquisition payment announcements. Quoted spreads are measured by two methods, quoted dollar spreads and quoted percentage spreads. The round-trip quoted dollar spread is defined as Quoted dollar spread ¼ St ¼ at bt , where St is the quoted dollar bid–ask spread, and at and bt are the quoted ask and bid prices, respectively, at time t. Following Ahn et al. (2001), the average dollar spread on a given day was calculated as the time weighted average of quoted spreads during the day: N P
AS ¼
ðT tþ1 T t ÞSt
t¼1
T Nþ1 T 1
,
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where AS denotes the daily average spread, Tt is the time in seconds at which the quote is posted by the specialist, T1 is the time when the first valid quote of the day is posted, and TN+1 is the exchange closing time. The average percentage quoted spread is calculated by replacing the quoted spread of the average dollar spread equation with the quote midpoint: N P
AS ¼ t¼1
ðT tþ1 T t Þ
at þbt
T Nþ1 T 1
2
.
Statistical tests for spread changes were completed for the three different payment types. While cash- and stock-financed acquisitions are hypothesized to show wider spreads in the pre-event period due to undervaluation or overvaluation, mixedfinanced acquisitions are hypothesized to show the same spreads in the pre- and post-event periods due to their fair valuation. To test the significance of changes in the spread from the pre-event to the post-event period, t-tests were used. The degree to which the bid–ask spreads in the pre-event period is different from those in the post-event period is determined at the ten-, five-, and one-percent significance levels. Since alternative hypotheses are made as one-sided tests, the p-value for a one tail test is calculated. The t-tests of bid–ask spreads are t¼
ASpre ASpost , SD
where ASpre is the average spread in pre-event period, ASpost is the average spread in post-event period, and SD is the standard error of the difference between the averages. 4.2. Depth To calculate the ask and bid depths, one must use the ask sizes and bid sizes in number of round lots. The average of ask depth and the average of the bid depth are then calculated using the average of the daily ask depth or bid depth in the pre- and post-event period. The daily ask and bid depths are the average of the ask and bid sizes on each day. t-Tests for ask and bid depth serve to test the significance of the difference in the two periods. The significance by which the depth in the pre-event period is different from the depth in the post-event period is determined at the ten-, five-, and one-percent levels. Alternative hypotheses are calculated based on one-sided tests and p-values for a one tail test are reported. Since a market maker reduces depth in the existence of informed traders, the level of ask or bid depth before a cash- or stock-financed acquisition payment announcement is hypothesized to be narrower than that after the acquisition payment announcement. No changes in ask and bid depth are hypothesized to be observed in the mixed-financed acquisitions in view of their fair valuation.
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The t-tests for ask depths are t¼
AADpre AADpost , SD
where AADpre is the average ask depth in the pre-event period, AADpost is the average ask depth in the post-event period, and SD is the standard error of the difference between the averages. The t-tests for bid depths are t¼
ABDpre ABDpost , SD
where ABDpre is the average bid depth in the pre-event period, ABDpost is the average bid depth in the post-event period, and SD is the standard error of the difference between the averages.
5. Results 5.1. Bid– ask spreads 5.1.1. The bid– ask spreads of hospitality cash-financed acquisitions If hospitality acquiring firms are undervalued, informed traders may purchase an acquiring firm’s shares prior to the acquisition payment announcement and the market maker will widen the bid–ask spread prior to cash-financed acquisitions. The result shows that the bid–ask spreads do not widen prior to acquisitions using cash financing. As Table 1 shows, the p-values for t-tests are not significant, implying that no informed trading occurred. At least two other confounding variables may influence these insignificant statistical results. First, the managers of hospitality acquiring firms may use cash financing because they use their firms’ free cash flow to diversify their firms or to avoid the dilution of managerial control after a merger. Second, daily dollar spreads and daily percentage spreads suddenly rise at 10 days before and 10 days
Table 1 Quoted spread of cash-financed acquisition announcements Difference
t-stat
p-value (one tail)
A. The quoted spread in cents (sample size ¼ 18) Mean 22.377 21.968 Variance 3.973 4.224
0.409
0.61
0.274
B. The percentage quoted spread (sample size ¼ 18) Mean 1.300 1.295 Variance 0.030 0.041
0.005
0.09
0.465
Pre-event (25, 2)
Post-event (+2, +25)
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after acquisition payment announcements. At 10 days before an acquisition payment announcement, eight acquiring firms have an earnings announcement or an investment rating change. At 10 days after the acquisition payment announcement, six acquirers using cash tender offers begin to tender their target shares. While no relationship is hypothesized between the acquisition announcement and these events, they may statistically influence the results because of the sample’s moderate size. 5.1.2. The bid– ask spreads of hospitality stock-financed acquisitions If hospitality acquiring firms are overvalued, informed traders may sell the acquiring firm’s shares prior to the acquisition payment announcement and the market maker will widen the bid–ask spread prior to stock-financed acquisitions. The results show that the bid–ask spreads do not widen prior to acquisitions using stock financing. As Table 2 shows, the p-values for the t-tests are not significant, a result inconsistent with informed trading prior to stock-financed acquisitions. 5.1.3. The bid– ask spreads of mixed-financed hospitality acquisitions If hospitality acquiring firms are fairly valued, informed traders are unlikely to purchase or sell the acquiring firm’s shares prior to the acquisition payment announcement and the market maker will not widen the bid–ask spread prior to mixed-financed acquisitions. The result shows that the bid–ask spreads widen prior to hospitality acquisitions using mixed financing. As Table 3 shows, the average quoted dollar spreads and the average percentage spreads in the pre-event period are significantly larger than the post-event period at the one-percent level. This result is inconsistent with a fair valuation of an acquiring hospitality firm before the acquisition announcement. A possible explanation exists for information asymmetry in mixed-financed acquisitions. Even though acquiring hospitality firms are fairly valued, cashrich acquiring firms may increase the cash component in a mixed-financed acquisition. Since, as Harford (1999) noted, an acquisition using free cash flow may have a net present value less than zero resulting in declining abnormal returns
Table 2 Quoted spread of stock-financed acquisition announcements Difference
t-stat
p-value (one tail)
A. The quoted spread in cents (sample size ¼ 33) Mean 26.092 26.456 Variance 2.730 2.337
0.364
0.95
0.824
B. The percentage quoted spread (sample size ¼ 33) Mean 1.416 1.534 Variance 0.018 0.007
0.118
3.35
0.999
Pre-event (25, 2)
Post-event (+2, +25)
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Table 3 Quoted spread of mixed-financed acquisition announcements Difference
t-stat
p-value (one tail)
A. The quoted spread in dollars (sample size ¼ 24) Mean 20.909 19.739 Variance 1.927 2.488
1.170
2.96*
0.003
B. The percentage quoted spread (sample size ¼ 24) Mean 1.283 1.162 Variance 0.018 0.028
0.121
2.61*
0.008
Pre-event (25, 2)
Post-event (+2, +25)
* significant at 1% level.
after the acquisition, informed traders may increase selling prior to the acquisition announcement forcing the market maker to widen the bid–ask spread. As an alternative, if the managerial ownership level of the acquiring hospitality firm is low, insiders may try to avoid selling and increase buying of their shares to maintain control in the combined firm. When insiders increase buying, the market maker widens the bid–ask spread. 5.2. Depth 5.2.1. Ask depth of cash-financed acquisitions If acquiring hospitality firms are undervalued, informed traders may purchase the acquiring firm’s shares prior to the acquisition payment announcement and the market maker will narrow the ask depth prior to cash-financed acquisitions. The results show that the ask depth becomes narrower prior to acquisitions using cash financing. As Table 4 shows, the t-test for the ask depth turns out significantly negative at the one-percent level, indicating that the ask depth of the pre-event period is significantly narrower than that of the post-event period. The average ask depth increased 27.5 percent from the pre-event to the post-event period, a result consistent with information asymmetry between informed traders and market makers about the acquiring firm’s economic value prior to cash-financed acquisitions. The market maker discourages informed traders from buying by reducing the ask depth prior to the hospitality acquisition announcement. 5.2.2. Bid depth of stock-financed hospitality acquisitions If acquiring hospitality firms are overvalued, informed traders may be tempted to sell their shares in the acquiring firm prior to the acquisition payment announcement and a market maker will narrow the bid depth prior to a stock-financed acquisition. The results show that the bid depth becomes narrower prior to hospitality acquisitions using stock financing. As Table 5 shows, the t-test is significantly negative at the one-percent level, indicating that the bid depth of the pre-event period is significantly narrower than that of the post-event period.
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Table 4 Ask depth around cash-financed acquisition announcements
Ask
Mean Variance
Pre-event (25, 2)
Post-event (+2, +25)
Difference
t-stat
p-value (one tail)
44.3 54.02
56.48 279.87
12.18
3.181*
0.001
Sample size ¼ 18. Both means and variances are calculated using units of 100 shares. * significant at 1% level.
Table 5 Bid depth around stock-financed acquisition announcements
Bid
Mean Variance
Pre-event (25, 2)
Post-event (+2, +25)
Difference
t-stat
p-value (one tail)
27.46 32.56
32.71 26.92
5.25
2.593*
0.005
Sample size ¼ 33. Both means and variances are calculated using units of 100 shares. * significant at 1% level.
The average bid depth increased by 19 percent from the pre-event to the post-event period, a result consistent with information asymmetry between informed traders and market makers about the acquiring hospitality firm’s economic value prior to stock-financed acquisitions. The market maker discourages these informed traders from selling by reducing the bid depths prior to the acquisition. 5.2.3. The bid/ask depths of mixed-financed hospitality acquisitions If acquiring hospitality firms are fairly valued, informed traders will be indifferent to purchasing the acquiring firm’s shares prior to the acquisition payment announcement and a market maker will not change the ask depth prior to the mixed financed acquisition. The result shows that the ask depth narrows prior to acquisitions using mixed financing. As Table 6 shows, the t-test indicates the ask depths increasing from pre- to post-event period at the one-percent significance level. This result is inconsistent with the hospitality firm’s shares being fairly valued in mixed-payment acquisitions. If the managerial ownership level of the acquiring firm is low, insiders may try to avoid selling and increase buying the firm’s shares to maintain their control in the combined firm. When insiders increase buying, a market maker narrows the ask depth. If acquiring hospitality firms are fairly valued, informed traders tend to be indifferent to selling the acquiring firm’s shares prior to an acquisition payment announcement and a market maker will not change the bid depth prior to a mixedfinanced acquisition. The result shows that the bid depth does not change prior to acquisitions using mixed financing. As Table 6 shows, the t-test indicated
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Table 6 Bid/ask depths around mixed-financed acquisition announcements Pre-event (25, 2)
Post-event (+2, +25)
Difference
t-stat
p-value (one tail)
2.223*
0.013
0.821
0.206
Ask
Mean Variance
37.25 34.05
47.6 99.18
10.35
Bid
Mean Variance
47.6 99.18
40.41 113.94
7.19
Sample size ¼ 24. Both means and variances are calculated using units of 100 shares. * significant at 1% level.
insignificant bid depth changes from the pre- to the post-event period. This result is consistent with the firm’s shares being valued fairly prior to the acquisition announcement.
6. Conclusion The results of this study support the fact that market makers try to avoid losses against informed traders prior to hospitality acquisition payment type announcements. In the short term (25 days prior to the announcement), when market makers notice informed trading for hospitality firms making subsequent mixed-financed acquisitions, they widen the bid–ask spread and narrow the ask depth. For cash- or stock-financed acquisitions, the bid–ask spread does not change, but the ask or bid depth narrows significantly prior to the acquisition payment announcement. The market makers reduce the bid depth to keep informed traders from selling in the case of a stock-financed hospitality acquisition. The market makers reduce the ask depth to keep informed traders from buying in the case of cash- and mixed-financed hospitality acquisitions. While the bid–ask spreads do not reveal significant changes prior to an acquisition payment announcement, the depths narrow in the same period because the depth measures the effect of informed buying and selling separately as the ask and bid depths, while the spread combines informed buying and selling together as the bid–ask spread. Since the change in depth due to informed traders prior to hospitality acquisition announcements can be observed, this does present an opportunity for financial analysts and other uninformed investors to try to imitate the informed trader’s trading patterns such as selling prior to stockfinanced acquisitions and buying prior to cash-financed acquisitions. Several confounding variables may help further explain the insignificant spread results. Cash-financed hospitality acquisitions often have earnings announcements, investment rating changes, or the tendering of target shares around the acquisition payment announcement. The bid–ask spread and depth can be changed by other variables such as the market maker’s inventory, trading volume, and competition from floor traders or competing dealers. The bid–ask spread can also vary depending
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on the firm size, price and risk of the security. One limitation of this study is that it considers only asymmetric information as the cause of market microstructure changes and ignores controlling the security’s characteristics. It might be useful in future research to explore the effect of the above confounding variables on hospitality market microstructure trading. In summary, this study provides evidence that informed traders use information asymmetry about a hospitality acquiring firm’s valuation to maximize their private benefits. Since informed traders include both actual insiders and other outsiders such as financial analysts or arbitrageurs, it remains unclear whether insiders and financial analysts behave differently in their market microstructure activities around hospitality corporate information events. Such differences and their impact on the financial market valuation of hospitality firms present a future research topic ideal for testing the strong form efficient market hypothesis in a different way. Also, as this study is the first to analyze the effect of acquisition payment type announcements on market microstructure trading (either in the general finance or hospitality finance literature), it offers a new avenue for future research into analyzing the behavior of informed traders of hospitality firms’ shares. Insights provided by the market microstructure approach may helpful in determining the efficiency of trading in hospitality firms, especially the smaller ones where public information may be somewhat limited.
References Ahn, H., Cao, C., Choe, H., 2001. Share repurchase tender offers and bid–ask spreads. Journal of Banking and Finance 25, 445–478. Akerlof, G., 1970. The market for ‘‘lemons’’: qualitative uncertainty and the market mechanism. Quarterly Journal of Economics 84 (3), 488–500. Bagehot, W., 1971. The only game in town. Financial Analysts Journal 22, 12–14. Canina, L., 2001. Acquisitions in the lodging industry: good news for buyers and sellers. Cornell Hotel and Restaurant Quarterly 42 (6), 47–54. Center of Research in Security Prices, retrieved January 10, 2003, from Wharton Research Data services on the World Wide Web: http://wrds.wharton.upenn.edu/ds/crsp/. Chung, K., McInish, T., Wood, R., Wyhowski, D., 1995. Production of information, information asymmetry, and the bid–ask spread: empirical evidence from analysts’ forecasts. Journal of Banking and Finance 19 (6), 1025–1046. Clarke, J., Fee, C., Thomas, S., 2004. Corporate diversification and asymmetric information: evidence from stock market trading characteristics. Journal of Corporate Finance 10, 105–129. Demsetz, H., 1968. The cost of transacting. Quarterly Journal of Economics 82, 33–53. Dow Jones News Service [Electronic data]. Dow Jones & Company, New York. Dupont, D., 2000. Market making, prices and quantity limits. The Review of Financial Studies 13 (4), 1129–1152. French, K., Roll, R., 1986. Stock return variance: the arrival of information and the reaction of traders. Journal of Financial Economics 17, 5–26. Harford, J., 1999. Corporate cash reserves and acquisitions. Journal of Finance 54 (6), 1969–1997. Harris, L., 2003. Trading and Exchanges: Market Microstructure for Practitioners. Oxford University Press, New York. Hotel and Motel Management (1983–1999). Advanstar communication, Cleveland, OH.
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Huang, R., Stoll, H., 1997. The components of the bid–ask spread: a general approach. The Review of Financial Studies 10 (4), 995–1034. Institute for the Study of Security Markets, retrieved January 10, 2003, from Wharton Research Data Services on the World Wide Web: http://wrds.wharton.upenn.edu/ds/issm/index.shtml. Kavajecz, K., 1999. A specialist’s quoted depth and the limit order book. Journal of Finance 54 (2), 747–771. Keown, A., Pinkerton, J., 1981. Merger announcements and insider trading activity: an empirical investigation. Journal of Finance 36, 855–869. Kyle, A., 1985. Continuous auctions and insider trading. Econometrica 53 (6), 1315–1335. Kwansa, F., 1994. Acquisitions, shareholder’s wealth and the lodging sector: 1980–1990. International Journal of Contemporary Hospitality Management 6 (6), 16–20. Lee, C., Mucklow, B., Ready, M., 1993. Spreads, depths, and the impact of earnings information: an intraday analysis. Review of Financial Studies 6 (2), 345–374. Lin, J., Sanger, G., Booth, G., 1995. Trade size and components of the bid–ask spread. Review of Financial Studies 8 (4), 1153–1183. Madhavan, A., 2000. Market microstructure: a survey. Journal of Financial Markets 3, 205–258. Mergerstat Review (1983–1999). Houlihan, Lokey, Howard & Zukin, Los Angeles, CA. Merger Yearbook (1983–1999). Securities Data Company, New York. National Restaurant News (1983–1999). Lebhar-Friedman, New York. Sheel, A., Nagpal, A., 2000. The post-merger equity value performance of acquiring firms in the hospitality industry. Journal of Hospitality Financial Management 8 (1), 37–45. Trade and Quote, Retrieved from January 10, 2003, from Wharton Research Data Services on the World Wide Web: http://wrds.wharton.upenn.edu/ds/taq/index.shtml. Varian, H., 1996. Intermediate Microeconomics: A Modern Approach, 5th ed. W.W. Norton & Co., New York. Wall Street Journal Index (1983–1999). Dow Jones & Co., New York.
Hospitality Management 25 (2006) 570–585 www.elsevier.com/locate/ijhosman
Detecting informed trading prior to hospitality acquisitions Seonghee Oaka,, William Andrewb a
Hospitality and Tourism Administration, School of Business, North Carolina Central University, P.O. Box 19716, Durham, NC 27707, USA b School of Hospitality Management, Pennsylvania State University, 201 Mateer University Park, PA 16802, USA
Abstract Hospitality acquisition payment announcements provide a particularly interesting opportunity for exploring the effects of information asymmetry on informed trading activities in hospitality firms. The empirical results in this paper, derived from a market microstructure approach, support the presence of informed trading in the short term prior to a hospitality acquisition. For cash- or stock-financed acquisitions, while we detect no change in the bid–ask spread of acquiring firms prior to an acquisition announcement, the ask or bid depths narrow prior to an acquisition payment announcement. For mixed-financed acquisitions, the bid–ask spread for acquiring firms widens and the ask depth narrows prior to the acquisition payment announcement. r 2005 Elsevier Ltd. All rights reserved. Keywords: Information asymmetry; Bid–ask spread; Depth; Acquisition
1. Introduction This study examines the effect of information asymmetry on informed trading activities related to the acquisition of hospitality firms. Because it is typical in hospitality corporations for ownership and management to be separate, corporate Corresponding author. Tel.: +1 919 530 6239; fax: +1 919 530 7865.
E-mail addresses: [email protected] (S. Oak), [email protected] (W. Andrew). 0278-4319/$ - see front matter r 2005 Elsevier Ltd. All rights reserved. doi:10.1016/j.ijhm.2005.04.005
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managers may acquire private information that outsiders, including stockholders, lack. Hospitality corporate acquisitions provide one situation where information asymmetry can occur. Managers of acquiring firms may base the type of payment they make to the target firm on their perception of the economic value of their own firm. When managers of acquiring firms perceive the shares of their own firms to be overvalued, they may use those shares to pay for the acquisition. When the managers of acquiring firms perceive their shares to be undervalued, they may avoid using those shares and instead pay for the acquisition in cash. When managers of acquiring firms perceive their shares to be fairly valued with all other factors being equal, they will be indifferent to using stock or cash and thus may use a mix of stock and cash as payment. In addition, when hospitality managers perceive their firm to be under- or overvalued, they may personally buy or sell their firm’s shares. In the case of an acquisition, when managers of hospitality acquiring firms perceive their shares to be overvalued and thus use those shares to purchase the target firm, they may sell their shares before the acquisition payment announcement. When managers of hospitality acquiring firms perceive their shares to be undervalued and use cash instead of stock for the acquisition, they may buy shares of their firm before the acquisition payment announcement. When managers of hospitality acquiring firms perceive their shares to be valued fairly and choose a mix of stock and cash to purchase the acquisition, they may be indifferent to buying or selling their shares on their personal account before the acquisition payment announcement. In addition to managers, other informed traders may undertake transactions with their personal accounts prior to hospitality acquisition payment announcements. These informed traders are categorized by the methods they use to estimate fundamental value into value traders (a category that includes managers), technical traders, and arbitrageurs. Value traders (including managers) estimate the fundamental value of a security using all the information available to them and an appropriate economic model. They then base their trading decisions on the fundamental value as compared to the market price of the security. Technical traders identify historical price patterns inconsistent with prices that fully reflect fundamental values. Arbitrageurs estimate relative differences in fundamental values. When informed traders compare their value estimates of an acquiring firm’s shares with the corresponding market price of the shares, they tend to buy shares or share derivatives they believe to be undervalued and sell shares or share derivatives they believe to be overvalued. The behavior of these informed traders may affect such security trading practices as the bid–ask spread and the bid and ask depth. This trading process is known as the market microstructure. This study measures informed trading using a market microstructure approach in the time period 25 days before and 25 days after the acquisition payment announcement. The short-term market microstructure analysis captures informed traders’ transactions attributable to information leakage close to the acquisition payment announcement. Hospitality acquisition payment announcements provide a particularly interesting opportunity to explore evidence of informed traders taking advantage of private
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information for their personal benefit as hospitality firms reflect a fairly unique set of firms, especially in respect to manufacturing firms. One can infer informed trading actions from changes in the bid–ask spread and depth around the hospitality acquisition payment announcement. In the short term, informed traders with private information may influence the bid–ask spread and the depth, which is set by market makers. If market makers notice informed trades in the market, they will widen the bid–ask spread and narrow the bid or the ask depth. This study is important since no previous hospitality research has addressed the process of informed trading around hospitality corporate events despite the importance of information asymmetry in the financial markets. Previous studies of hospitality acquisitions only focused on the stock market reaction through event studies (Canina, 2001; Sheel and Nagpal, 2000; Kwansa, 1994). In addition, these studies of hospitality acquisitions typically focused on acquisitions occurring during a limited time period. Since this study examines all acquisitions in the hospitality industry between 1983 and 1999, it presents a comprehensive picture of hospitality acquisition activities. This study also represents the first formal empirical research to use the market microstructure method in hospitality finance. If information asymmetry exists in a hospitality acquisition, this study should demonstrate whether informed trading influences the process of price adjustment in the market microstructure.
2. Literature review 2.1. Information asymmetry theory Financial analysts tend to explain market price by reference to complete information, where buyers and sellers have an equal knowledge of the quality of goods (Varian, 1996). This equality occurs when market participants can easily obtain information without spending a great deal of time and money on an information search. Easily accessible information results in market prices quickly reflecting differences in the quality of various goods. But in the real world, acquiring a complete body of information can be expensive. In the real world, information may be ‘‘asymmetrical,’’ and one can categorize market participants as either informed or uninformed. Those with relevant private information are among the informed. When informed traders trade securities with uninformed traders, they can adversely affect the interests of the uninformed in the market. This situation is called an ‘‘adverse selection problem,’’ which appears familiarly in the used car business. In the case of an acquisition announcement, managers and other informed traders tend to be informed and market makers tend to be uninformed. These informed traders can adversely affect market makers and outside investors by engaging in insider trading. In the used-car market, a seller tends to have better information about the quality of a car than a prospective buyer does (Akerlof, 1970). Even though the owner of a new car may have driven it only a few kilometers and the car, now used, remains in perfect condition, a subsequent buyer cannot readily distinguish it from a so-called
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‘‘lemon.’’ Since lemons tend to drive out good cars in the used car market, the average quality there tends to be lower relative to the average price. Similarly, with hospitality acquisition announcements, outside investors and market makers rarely know if good or poor prospects exist for the combined firms, but managers in acquiring firms may have this information. In the case that hospitality managers perceive poor prospects for their firms, the managers and other informed traders can use their private information to sell their firms’ shares on their personal account and this trading can lessen the market value of their firms for outside investors and adversely affect market makers in the stock. 2.2. Market microstructure French and Roll (1986) studied the impact of private information on the financial markets, and they indicated that most return volatility in stock markets is caused by public information that arrives during normal business hours and by private information that affects prices through informed trading. French and Roll showed return variances for weekday exchange trading hours to be higher than for weekends and holidays. This result implies that informed investors are more likely to trade when the exchanges are open. Low daily variance ratios relate strongly to exchange holidays because private information can affect prices only through informed trading; in this case, the price reaction is delayed until informed trading occurs. In the study reported here, the use of the market microstructure approach around hospitality acquisition payment announcements focuses on the arrival of private information from informed trading prior to the acquisition of the public information during normal trading hours. No previous studies, either in hospitality or in general finance, have examined the impact of different payment types for an acquisition on market microstructure trading. As such, the study presented here breaks new ground in both the general finance and the hospitality finance literature. In the trading process of the market microstructure, market makers, who function as match makers between buyers and sellers, play an important role. Demsetz (1968) concluded that market makers take responsibility for an immediate exchange of titles to securities and they control the bid–ask spread so as to maximize their own profits and minimize their own losses. They match buy and sell orders and hold an inventory of securities used to fill unmatched orders. Market makers make a profit from the ‘‘spread,’’ the difference between the buying (ask) and selling (bid) price per share. The bid–ask spread is a function of several variables including trading volume, the market maker’s inventory, competition, and asymmetric information among informed investors and the market maker (Madhavan, 2000). In addition, Clarke et al. (2004) report that the degree of firm’s diversification causes bid–ask spread changes. An informed trader makes profits by trading with a market maker who is unaware of the firm specific information the informed trader possesses. Since informed trading increases a market maker’s costs, it also affects the bid–ask spread (Bagehot, 1971). In addition to informed traders, market makers also deal with liquidity traders, who convert securities into cash and have no special information. As Kyle (1985) first suggested, a dynamic model with sequential auctions includes two steps
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for insider trading: (1) the insider and the liquidity traders simultaneously choose the quantities they will trade; and (2) the market maker sets a price and trades the quantity that clears the market. Kyle discussed the constant volatility that information incorporates into prices. In his model, all of the insider’s private information is incorporated into prices by the end of trading. Thus, around acquisition payment announcements, one would expect information asymmetry eventually to disappear and the market price to reflect the impact of managerial private information. Market makers cannot distinguish between informed traders and liquidity traders. But when they detect unusual changes in prices or volume, they widen the bid–ask spread to prevent losses against informed traders and to gain protection against liquidity traders (Bagehot, 1971). When market makers detect unusual buying, they raise the ask price to discourage further purchases. When they detect unusual selling, they lower the bid price to discourage further sales (Harris, 2003). Hence, the bid–ask spreads should become wider prior to hospitality acquisitions using stock and cash financing. Likewise, the bid–ask spreads would not be expected to change prior to hospitality acquisitions using mixed financing. Information-based microstructure models have been used to explain bid–ask spread changes under information asymmetry. In 1985, Glosten and Milgrom reported that the bid–ask spread increased when buy (sell) orders forced market makers to revise their expectations of the stock value upward (downward) and forced their quotes to move accordingly. Since the study reported here focuses on the existence of private information around hospitality acquisition payment announcements, it examines changes in bid–ask spreads caused potentially by information asymmetry. One normally uses a short period, 25 days before and 25 days after the acquisition payment announcement, to measure the market microstructure process (Ahn et al., 2001). Changes in market depth provide yet another way of detecting informed traders. But the role of quoted depth has received little research attention. Dupont (2000) suggested that depth is more sensitive than the bid–ask spread to a change in the quality of the informed traders’ information. Kavajecz (1999) offered theoretical support that spreads will widen and depths will fall in response to an increase of information asymmetry between informed traders and market makers. On the NYSE, a complete quote includes the best price available for purchase (the ask) and sale (the bid), as well as the number of shares available at each price (the depth) (Lee et al., 1993). When market makers detect unusual buying, they lower the ask depth to discourage further purchases. When market makers detect unusual selling, they lower the bid depth to discourage further sales (Harris, 2003). Chung et al. (1995) provided additional evidence on the market maker’s involvement in the market microstructure. Since the market maker controlling the bid–ask spread under information asymmetry can be observed, financial analysts utilize the market maker’s behavior to find a stock with a greater extent of information asymmetry due to the higher value of private information. Given an increasing probability of informed traders, market makers may respond with a narrower ask depth prior to hospitality acquisitions using cash financing and a narrower bid depth prior to
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hospitality acquisitions using stock financing. There should be no change of depth prior to hospitality acquisitions using mixed financing. The presence of information asymmetry can influence market prices adversely. Although regulations relating to insider trading exist to protect uninformed investors against informed investors, they do not always prevent insider trading. Hence, the existence of private information still presents opportunities for insider and informed traders to benefit disproportionately. Previous studies confirm active insider trading over periods prior to corporate information events—for example, increased insider selling and decreased insider buying before corporate seasoned equity issues. Although informed trading is difficult to detect, a market microstructure approach in the short term can help identify information asymmetry prior to a hospitality acquisition payment announcement by detecting changes in the bid–ask spread and bid or ask depth before and after the acquisition payment announcement date. 2.3. Research hypotheses Bid–ask spread hypotheses are expressed as the following. ASpre is the average spread in the pre-event period 25 days before the hospitality acquisition payment announcement and ASpost is the average spread in the post-event period 25 days after the hospitality acquisition payment announcement. For hospitality acquiring firms using cash financing Ho1 : ASpre pASpost ; Ha1 : ASpre 4ASpost : For hospitality acquiring firms using stock financing Ho2 : ASpre pASpost ; Ha2 : ASpre 4ASpost . For hospitality acquiring firms using mixed financing Ho3 : ASpre pASpost ; Ha3 : ASpre 4ASpost . Depth hypotheses are expressed as the following. AADpre is the average ask depth in the pre-event period and AADpost is the average ask depth in the post-event period. Also, ABDpre is the average bid depth in the pre-event period and ABDpost is the average bid depth in the post-event period. For hospitality acquiring firms using cash financing Ho4 : AADpre XAADpost ; Ha4 : AADpre oAADpost . For hospitality acquiring firms using stock financing Ha5 : ABDpre XABDpost ; Ho5 : ABDpre oABDpost . For hospitality acquiring firms using mixed financing Ho6 : AADpre XAADpost ; Ha6 : AADpre oAADpost , Ho7 : ABDpre XABDpost ; Ha7 : ABDpre oABDpost .
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3. Data 3.1. The sample of hospitality firms making acquisitions The authors searched the Center for Research in Security Prices (CRSP) tapes for all NYSE, AMEX, and Nasdaq hospitality firms delisted during 1983–1999 (SIC industry codes: hotel 7011, restaurant 5812, casino 7999, and cruise 4481). This study examined hospitality acquisitions only after 1983, because data for analyzing the market microstructure are available only after that year. The CRSP tapes define firms delisted because of acquisition with delisting codes between 200 and 203. After identifying the delisted firms (targets), the authors consulted the Wall Street Journal Index to determine the acquiring firms. Trade magazines like Hotel & Motel Management and National Restaurant News provided additional deals unrecorded among the delisted firms in the CRSP tapes. In addition to these sources, the Mergerstat Review and the Merger Yearbook served to identify acquisitions in the hospitality industry. The search produced a total of 111 acquisitions, which represent the entire public population of acquisitions in the hospitality industry between 1983 and 1999. The authors divided their sample of hospitality acquiring firms into three subsets based on the acquisition payment type (cash, stock and mixed) in the announcement as reported in the Dow Jones News Service (DJNS). If the payment type for the observation was unknown, the acquisition was excluded from this study, which reduced the 111 announcements to 81. The first subset of observations is the stock-payment group where only the acquirer’s common stock was used to pay for an acquisition (35 of the 81 observations). The second subset of observations is the cash-payment group where only cash was used to pay for an acquisition (20 of the 81 observations). The last subset of observations is the mixed-payment group in which both cash and stock were used to pay for an acquisition (26 of the 81 observations). 3.2. Microstructure data In order to test the bid–ask spread and depth hypotheses, the authors drew data from the Trade and Quote (TAQ) database, which contains all the trades and quotes for stocks listed on the NYSE, the AMEX and Nasdaq’s National Market System (NMS). Since the TAQ data were available only after 1993, the authors used Institute for the Study of Security Markets (ISSM) transaction data files, which contain trades and quotes, for the period from 1983 to 1992. From a total sample of 81 collected hospitality acquisitions, 75 observations proved to be suitable for the market microstructure study. Six observations were dropped because of the lack of historical trades and quotes in either the ISSM or TAQ data. Throughout this study, the market microstructure test period is divided into three periods: pre-event, event and post-event (Ahn et al., 2001). The event day is defined as the first day on the DJNS when the firm announced the acquisition
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payment type (three acquisition payment announcements did have prior acquisition announcements). The event period consists of 3 days, which is from 1 trading day prior to the acquisition payment announcement to 1 trading day subsequent to the announcement. The pre-event period ran from 25 trading days to 2 trading days prior to the acquisition payment announcement day. The post-event period ran from 2 trading days to 25 trading days subsequent to the acquisition payment announcement day. Previous studies imply a positive relationship between information leakage and stock price run-up 3 weeks prior to acquisition announcements (notably Keown and Pinkerton, 1981; Ahn et al., 2001). Accordingly, this study used 25 trading days before and after the acquisition payment announcement date as its cutoff dates. A series of filters served to clean the trade and quote data used for the market microstructure analysis. Nonstandard delivery trades and all quotes that were not Best Bid and Offer (BBO) eligible were discarded (Ahn et al., 2001). BBO-ineligible quotes include closing quotations, trading halts, pre-opening indications, and nonfirm quotations. All trades and quotes that were time-stamped before 9:30 a.m. EST (market opening) or after 4:00 p.m. EST (market closing) were also discarded. Pre-opening transactions were excluded from the sample because they were conducted in a call market, while transactions after the opening were generally conducted in a continuous auction market (Lin et al., 1995; Huang and Stoll, 1997). Quotes were also excluded if they originated from markets other than the primary exchange where the stock was listed. For the announcement time, the Dow Jones News Service (DJNS) database provided day and time stamps to the minute. If the announcement of an offer came after 4:00 p.m. EST, the next trading day became the announcement date (Ahn et al., 2001).
4. Methodology 4.1. Quoted spread To calculate the quoted spread, one needs the ask and bid price for 25 days before and 25 days after acquisition payment announcements. Quoted spreads are measured by two methods, quoted dollar spreads and quoted percentage spreads. The round-trip quoted dollar spread is defined as Quoted dollar spread ¼ St ¼ at bt , where St is the quoted dollar bid–ask spread, and at and bt are the quoted ask and bid prices, respectively, at time t. Following Ahn et al. (2001), the average dollar spread on a given day was calculated as the time weighted average of quoted spreads during the day: N P
AS ¼
ðT tþ1 T t ÞSt
t¼1
T Nþ1 T 1
,
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where AS denotes the daily average spread, Tt is the time in seconds at which the quote is posted by the specialist, T1 is the time when the first valid quote of the day is posted, and TN+1 is the exchange closing time. The average percentage quoted spread is calculated by replacing the quoted spread of the average dollar spread equation with the quote midpoint: N P
AS ¼ t¼1
ðT tþ1 T t Þ
at þbt
T Nþ1 T 1
2
.
Statistical tests for spread changes were completed for the three different payment types. While cash- and stock-financed acquisitions are hypothesized to show wider spreads in the pre-event period due to undervaluation or overvaluation, mixedfinanced acquisitions are hypothesized to show the same spreads in the pre- and post-event periods due to their fair valuation. To test the significance of changes in the spread from the pre-event to the post-event period, t-tests were used. The degree to which the bid–ask spreads in the pre-event period is different from those in the post-event period is determined at the ten-, five-, and one-percent significance levels. Since alternative hypotheses are made as one-sided tests, the p-value for a one tail test is calculated. The t-tests of bid–ask spreads are t¼
ASpre ASpost , SD
where ASpre is the average spread in pre-event period, ASpost is the average spread in post-event period, and SD is the standard error of the difference between the averages. 4.2. Depth To calculate the ask and bid depths, one must use the ask sizes and bid sizes in number of round lots. The average of ask depth and the average of the bid depth are then calculated using the average of the daily ask depth or bid depth in the pre- and post-event period. The daily ask and bid depths are the average of the ask and bid sizes on each day. t-Tests for ask and bid depth serve to test the significance of the difference in the two periods. The significance by which the depth in the pre-event period is different from the depth in the post-event period is determined at the ten-, five-, and one-percent levels. Alternative hypotheses are calculated based on one-sided tests and p-values for a one tail test are reported. Since a market maker reduces depth in the existence of informed traders, the level of ask or bid depth before a cash- or stock-financed acquisition payment announcement is hypothesized to be narrower than that after the acquisition payment announcement. No changes in ask and bid depth are hypothesized to be observed in the mixed-financed acquisitions in view of their fair valuation.
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The t-tests for ask depths are t¼
AADpre AADpost , SD
where AADpre is the average ask depth in the pre-event period, AADpost is the average ask depth in the post-event period, and SD is the standard error of the difference between the averages. The t-tests for bid depths are t¼
ABDpre ABDpost , SD
where ABDpre is the average bid depth in the pre-event period, ABDpost is the average bid depth in the post-event period, and SD is the standard error of the difference between the averages.
5. Results 5.1. Bid– ask spreads 5.1.1. The bid– ask spreads of hospitality cash-financed acquisitions If hospitality acquiring firms are undervalued, informed traders may purchase an acquiring firm’s shares prior to the acquisition payment announcement and the market maker will widen the bid–ask spread prior to cash-financed acquisitions. The result shows that the bid–ask spreads do not widen prior to acquisitions using cash financing. As Table 1 shows, the p-values for t-tests are not significant, implying that no informed trading occurred. At least two other confounding variables may influence these insignificant statistical results. First, the managers of hospitality acquiring firms may use cash financing because they use their firms’ free cash flow to diversify their firms or to avoid the dilution of managerial control after a merger. Second, daily dollar spreads and daily percentage spreads suddenly rise at 10 days before and 10 days
Table 1 Quoted spread of cash-financed acquisition announcements Difference
t-stat
p-value (one tail)
A. The quoted spread in cents (sample size ¼ 18) Mean 22.377 21.968 Variance 3.973 4.224
0.409
0.61
0.274
B. The percentage quoted spread (sample size ¼ 18) Mean 1.300 1.295 Variance 0.030 0.041
0.005
0.09
0.465
Pre-event (25, 2)
Post-event (+2, +25)
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after acquisition payment announcements. At 10 days before an acquisition payment announcement, eight acquiring firms have an earnings announcement or an investment rating change. At 10 days after the acquisition payment announcement, six acquirers using cash tender offers begin to tender their target shares. While no relationship is hypothesized between the acquisition announcement and these events, they may statistically influence the results because of the sample’s moderate size. 5.1.2. The bid– ask spreads of hospitality stock-financed acquisitions If hospitality acquiring firms are overvalued, informed traders may sell the acquiring firm’s shares prior to the acquisition payment announcement and the market maker will widen the bid–ask spread prior to stock-financed acquisitions. The results show that the bid–ask spreads do not widen prior to acquisitions using stock financing. As Table 2 shows, the p-values for the t-tests are not significant, a result inconsistent with informed trading prior to stock-financed acquisitions. 5.1.3. The bid– ask spreads of mixed-financed hospitality acquisitions If hospitality acquiring firms are fairly valued, informed traders are unlikely to purchase or sell the acquiring firm’s shares prior to the acquisition payment announcement and the market maker will not widen the bid–ask spread prior to mixed-financed acquisitions. The result shows that the bid–ask spreads widen prior to hospitality acquisitions using mixed financing. As Table 3 shows, the average quoted dollar spreads and the average percentage spreads in the pre-event period are significantly larger than the post-event period at the one-percent level. This result is inconsistent with a fair valuation of an acquiring hospitality firm before the acquisition announcement. A possible explanation exists for information asymmetry in mixed-financed acquisitions. Even though acquiring hospitality firms are fairly valued, cashrich acquiring firms may increase the cash component in a mixed-financed acquisition. Since, as Harford (1999) noted, an acquisition using free cash flow may have a net present value less than zero resulting in declining abnormal returns
Table 2 Quoted spread of stock-financed acquisition announcements Difference
t-stat
p-value (one tail)
A. The quoted spread in cents (sample size ¼ 33) Mean 26.092 26.456 Variance 2.730 2.337
0.364
0.95
0.824
B. The percentage quoted spread (sample size ¼ 33) Mean 1.416 1.534 Variance 0.018 0.007
0.118
3.35
0.999
Pre-event (25, 2)
Post-event (+2, +25)
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Table 3 Quoted spread of mixed-financed acquisition announcements Difference
t-stat
p-value (one tail)
A. The quoted spread in dollars (sample size ¼ 24) Mean 20.909 19.739 Variance 1.927 2.488
1.170
2.96*
0.003
B. The percentage quoted spread (sample size ¼ 24) Mean 1.283 1.162 Variance 0.018 0.028
0.121
2.61*
0.008
Pre-event (25, 2)
Post-event (+2, +25)
* significant at 1% level.
after the acquisition, informed traders may increase selling prior to the acquisition announcement forcing the market maker to widen the bid–ask spread. As an alternative, if the managerial ownership level of the acquiring hospitality firm is low, insiders may try to avoid selling and increase buying of their shares to maintain control in the combined firm. When insiders increase buying, the market maker widens the bid–ask spread. 5.2. Depth 5.2.1. Ask depth of cash-financed acquisitions If acquiring hospitality firms are undervalued, informed traders may purchase the acquiring firm’s shares prior to the acquisition payment announcement and the market maker will narrow the ask depth prior to cash-financed acquisitions. The results show that the ask depth becomes narrower prior to acquisitions using cash financing. As Table 4 shows, the t-test for the ask depth turns out significantly negative at the one-percent level, indicating that the ask depth of the pre-event period is significantly narrower than that of the post-event period. The average ask depth increased 27.5 percent from the pre-event to the post-event period, a result consistent with information asymmetry between informed traders and market makers about the acquiring firm’s economic value prior to cash-financed acquisitions. The market maker discourages informed traders from buying by reducing the ask depth prior to the hospitality acquisition announcement. 5.2.2. Bid depth of stock-financed hospitality acquisitions If acquiring hospitality firms are overvalued, informed traders may be tempted to sell their shares in the acquiring firm prior to the acquisition payment announcement and a market maker will narrow the bid depth prior to a stock-financed acquisition. The results show that the bid depth becomes narrower prior to hospitality acquisitions using stock financing. As Table 5 shows, the t-test is significantly negative at the one-percent level, indicating that the bid depth of the pre-event period is significantly narrower than that of the post-event period.
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Table 4 Ask depth around cash-financed acquisition announcements
Ask
Mean Variance
Pre-event (25, 2)
Post-event (+2, +25)
Difference
t-stat
p-value (one tail)
44.3 54.02
56.48 279.87
12.18
3.181*
0.001
Sample size ¼ 18. Both means and variances are calculated using units of 100 shares. * significant at 1% level.
Table 5 Bid depth around stock-financed acquisition announcements
Bid
Mean Variance
Pre-event (25, 2)
Post-event (+2, +25)
Difference
t-stat
p-value (one tail)
27.46 32.56
32.71 26.92
5.25
2.593*
0.005
Sample size ¼ 33. Both means and variances are calculated using units of 100 shares. * significant at 1% level.
The average bid depth increased by 19 percent from the pre-event to the post-event period, a result consistent with information asymmetry between informed traders and market makers about the acquiring hospitality firm’s economic value prior to stock-financed acquisitions. The market maker discourages these informed traders from selling by reducing the bid depths prior to the acquisition. 5.2.3. The bid/ask depths of mixed-financed hospitality acquisitions If acquiring hospitality firms are fairly valued, informed traders will be indifferent to purchasing the acquiring firm’s shares prior to the acquisition payment announcement and a market maker will not change the ask depth prior to the mixed financed acquisition. The result shows that the ask depth narrows prior to acquisitions using mixed financing. As Table 6 shows, the t-test indicates the ask depths increasing from pre- to post-event period at the one-percent significance level. This result is inconsistent with the hospitality firm’s shares being fairly valued in mixed-payment acquisitions. If the managerial ownership level of the acquiring firm is low, insiders may try to avoid selling and increase buying the firm’s shares to maintain their control in the combined firm. When insiders increase buying, a market maker narrows the ask depth. If acquiring hospitality firms are fairly valued, informed traders tend to be indifferent to selling the acquiring firm’s shares prior to an acquisition payment announcement and a market maker will not change the bid depth prior to a mixedfinanced acquisition. The result shows that the bid depth does not change prior to acquisitions using mixed financing. As Table 6 shows, the t-test indicated
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Table 6 Bid/ask depths around mixed-financed acquisition announcements Pre-event (25, 2)
Post-event (+2, +25)
Difference
t-stat
p-value (one tail)
2.223*
0.013
0.821
0.206
Ask
Mean Variance
37.25 34.05
47.6 99.18
10.35
Bid
Mean Variance
47.6 99.18
40.41 113.94
7.19
Sample size ¼ 24. Both means and variances are calculated using units of 100 shares. * significant at 1% level.
insignificant bid depth changes from the pre- to the post-event period. This result is consistent with the firm’s shares being valued fairly prior to the acquisition announcement.
6. Conclusion The results of this study support the fact that market makers try to avoid losses against informed traders prior to hospitality acquisition payment type announcements. In the short term (25 days prior to the announcement), when market makers notice informed trading for hospitality firms making subsequent mixed-financed acquisitions, they widen the bid–ask spread and narrow the ask depth. For cash- or stock-financed acquisitions, the bid–ask spread does not change, but the ask or bid depth narrows significantly prior to the acquisition payment announcement. The market makers reduce the bid depth to keep informed traders from selling in the case of a stock-financed hospitality acquisition. The market makers reduce the ask depth to keep informed traders from buying in the case of cash- and mixed-financed hospitality acquisitions. While the bid–ask spreads do not reveal significant changes prior to an acquisition payment announcement, the depths narrow in the same period because the depth measures the effect of informed buying and selling separately as the ask and bid depths, while the spread combines informed buying and selling together as the bid–ask spread. Since the change in depth due to informed traders prior to hospitality acquisition announcements can be observed, this does present an opportunity for financial analysts and other uninformed investors to try to imitate the informed trader’s trading patterns such as selling prior to stockfinanced acquisitions and buying prior to cash-financed acquisitions. Several confounding variables may help further explain the insignificant spread results. Cash-financed hospitality acquisitions often have earnings announcements, investment rating changes, or the tendering of target shares around the acquisition payment announcement. The bid–ask spread and depth can be changed by other variables such as the market maker’s inventory, trading volume, and competition from floor traders or competing dealers. The bid–ask spread can also vary depending
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on the firm size, price and risk of the security. One limitation of this study is that it considers only asymmetric information as the cause of market microstructure changes and ignores controlling the security’s characteristics. It might be useful in future research to explore the effect of the above confounding variables on hospitality market microstructure trading. In summary, this study provides evidence that informed traders use information asymmetry about a hospitality acquiring firm’s valuation to maximize their private benefits. Since informed traders include both actual insiders and other outsiders such as financial analysts or arbitrageurs, it remains unclear whether insiders and financial analysts behave differently in their market microstructure activities around hospitality corporate information events. Such differences and their impact on the financial market valuation of hospitality firms present a future research topic ideal for testing the strong form efficient market hypothesis in a different way. Also, as this study is the first to analyze the effect of acquisition payment type announcements on market microstructure trading (either in the general finance or hospitality finance literature), it offers a new avenue for future research into analyzing the behavior of informed traders of hospitality firms’ shares. Insights provided by the market microstructure approach may helpful in determining the efficiency of trading in hospitality firms, especially the smaller ones where public information may be somewhat limited.
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