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Asian Review of Financial Research Vol.27 No.4 pp.631-668
Informed Trading before Analyst Recommendation Changes
Tae-Jun Park Senior Researcher, Korea Capital Market Institute
Kyojik Roy Song* Professor, Business School, Sungkyunkwan University
Key Words : Information Asymmetry,Informed Trading,Analyst Recommendation Changes,Trade Imbalance,Institutional Investors


Analyst reports, which contain views on whether to buy or sell particular stocks for clients, usually include earnings forecasts, long-term growth forecasts, and /or stock recommendations. In general, analysts' stock recommendations fall into one of five categories: strong buy, buy, hold, sell, or strong sell. Analysts revise their recommendations by upgrading or downgrading them when needed. The recommendation changes are commonly regarded as useful information and lead to changes in stock prices. Investors expect analysts to provide objective, unbiased, and accurate equity research reports based on the best of their knowledge. However, the literature has accumulated evidence that sell-side analysts' forecasts are tainted and not objective. Sell-side analysts working for investment bank shave pressure to provide optimistic recommendations on firms that can provide business to the investment banks. Analysts working in brokerage houses also have pressure to provide optimistic recommendations to attract trading revenues because upgrades attract more business than downgrades due to restrictions on short selling. Consistent with this conflict of interest, previous literature has found that analysts affiliated with investment banks and brokers produce more optimistic earnings and are more likely to give buy recommendations. In addition, if some investors have access to the contents of upcoming analysts' reports in advance, then they can take advantage of the superior information contained in those reports. Irvine, Lipson, and Puckett (2007) test the “tipping hypothesis” based on data on initial recommendations and document that brokerage firms provide the contents of affiliated analyst reports to important clients who generate large trading commissions before the information becomes public. We extend this line of research by examining the daily trading data on Korean stock recommendation changes from 2001 to 2010. The advantage of using Korean data is that we can obtain the daily trading volume by investor types for all stocks traded on the Korean Stock Exchange (KSE) and on the Korea Securities Dealers Automated Quotation (KOSDAQ). Our sample consists of 1,708 upgrades and 2,035 downgrades for 223 unique industrial firms. By analyzing investors' trading data on the recommendation changes of analysts, we examine whether information asymmetry exists among different groups of investors, individuals, domestic buy-side institutions, and foreign investors. Unlike individual investors, institutions frequently communicate with brokerage firms, investment banks, and asset management firms to acquire information, which makes it possible for them to access analysts' reports. In addition, institutions are more capable of acquiring and processing information than individuals. We thusconjecture that domestic buy-side institutions are better informed than individuals on upcoming recommendation changes. We also investigate whether foreigners have an informational advantage compared to domestic investors on the upcoming recommendation changes. Previous studies provide inconclusive evidence that foreigners perform better than domestic investors in trading stocks. Using Korean data, Choe, Kho, and Stulz (2005) find no evidence that foreign investors perform better than domestic institutions. Our analysis shows that stock prices increase before analysts' recommendation upgrades, whereas upcoming downgrades do not cause stock prices to decrease before the information release. We then analyze the standardized trade imbalance (STI) to examine the difference in trading activities by individuals, domestic institutions, and foreigners before recommendation changes. Over the period of days -5 to -1, the STI by domestic buy-side institutions is 0.43 before upgrades and -.35 before downgrades, and the STIs are significantly different from zero at the 1% confidence level. However, the STIs by individuals and foreigners before recommendation changes are not statistically different from zero. These results indicate that domestic buy-side institutions buy (sell) stocks in anticipation of an upgrade (downgrade), whereas individual investors and foreign investors do not trade stocks based on information. We also find that trade imbalances by the institutions are positively related to abnormal returns over days 0 to 5 after the announcements of recommendation changes. This evidence is consistent with our argument that domestic buy-side institutions take advantage of their superior information on analyst recommendation changes over the short-term. Our paper adds to the literature by providing evidence of the short-term informational advantage of domestic buy-side institutions over other investors on analysts' recommendation changes based on high-frequency data from Korea. The evidence shows that domestic institutions predict the direction of analysts' recommendation changes and reflect this information in their stock trading, which is indirectly consistent with Irvine, Lipson, and Puckett's (2007) finding. We also contribute to the growing literature on foreign investors' trading in emerging markets. We find that foreign institution trading is not characteristic of analysts' recommendation changes and does not predict stock returns. This shows that foreign institutions do not have an informational advantage compared to local institutions on specific events.
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