Predicting informed trading at merger announcements

Abstract

Purpose -This paper aims to propose a method of forecasting the level of informed trading at merger announcements by permitting liquidity traders to adjust their trading based upon signals from informed traders. Informed traders typically take advantage of their knowledge of forthcoming mergers by trading heavily at announcement. For cash mergers, they respond to a positive signal by purchasing stock, and for stock mergers, they respond to a negative signal by selling stock. In response, exchanges (market makers) set wider spreads (charge higher transaction fees) for informed buyers. Uninformed traders are subject to such excessive fees unless they can accurately predict the period during which such fees are charged. Design/methodology/approach -This paper proposes a technique by which uninformed traders may make predictions by creating a vector autoregressive framework that links informed and liquidity trading through price changes. Findings -For cash mergers, transaction fees remained excessive for days 21 to þ 1. For stock mergers, fees remained high on days 21 to þ 1, started declining on days 2 and 3, and vanished on days 4 and 5. Research limitations/implications -Most theoretical models of informed trading have viewed informed trading and liquidity trading as tangentially linked. This study finds a direct link between these two trading activities. Practical implications -Uninformed traders may wish to limit their trading until after day þ 1 for both types of mergers. Originality/value -This paper defines the time period during which transactions costs for traders are at the maximum level. Short sellers have more information about the direction of stock movements and may sell during days of informed selling set forth by this study and repurchase stock afterwards.

Trading Responses to Negative Signals

“…Our model incorporates trading by liquidity traders (usually institutional traders) in the form of stock and call option purchases, to purchase cheap stock and put purchases and stock sales to maintain liquidity. This is in accordance with Abraham and Harrington [4] who found that liquidity traders sell stock during the merger announcement period as measured by the decline in transaction costs from day −1 to day +2. Our inclusion of liquidity traders as market participants is in contrast to the perception in the literature that such traders are noise traders who are "willing to trade even though from an objective point of view they would be better off not trading" (Black [5], p. 529).…”

“…Trading occurs primarily on days 1 -5 following the merger. Abraham and Harrington [4] detected liquidity buying and selling during this time period by evaluating spreads. Market makers set spreads wide for informed traders and narrowed them for liquidity traders.…”

“…They may purchase stock that is losing value to obtain bargains or sell stock to avoid further losses. Their desire is not to profit from the merger announcement, but to hold a portfolio that achieves long-term growth (Abraham and Harrington [4]). We construct a theoretical model that specifies that informed trader expectations of future stock prices as contained in short sale volumes and put purchase volumes form a lower bound while call sale volumes form the upper bound.…”

Determinants of Oil Futures Prices

“…Eventually, the strategy ceases to yield a gain as rising put premiums completely offset any gains from declining oil futures prices. In successive studies, [8] and [9] empirically and theoretically proved the existence of lower bounds for call sell and put purchase trading strategies.…”