Inside Trading

Insider Trading in Derivative Securities: An Empirical Examination of the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders

J. Carr Bettis School of Management Arizona State University West cbettis@camelbackra.com

John M. Bizjak Department of Finance College of Business Portland State University johnb@sba.pdx.edu

Michael L. Lemmon Department of Finance College of Business Arizona State University mlemmon@asu.edu

First Draft: January 25, 1999 Current Draft: May 31, 1999

Please do not quote without the authors’ permission. This paper was previously titled “Can Insiders Hide Trades in Their Own Equity? An Empirical Examination of the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders”. This paper has benefited from the helpful comments of seminar participants at Arizona State University, the University of Oregon, Portland State University, and the Securities and Exchange Commission.

ABSTRACT

We provide an examination of the use of zero-cost collars and equity swaps by corporate insiders to hedge the risk associated with their personal holdings in the company’s equity. These financial instruments have important implications for insider trading and incentive-based contracts. Our analysis indicates that these transactions generally involve high ranking insiders (CEOs, board members and senior executives) and cover over a third of their equity holdings. We also find that insiders appear to initiate hedging transactions immediately following large price runups, prior to increases in stock price volatility, and prior to poor earnings announcements. In addition, abnormal returns following insider hedging activities are more negative than those associated with ordinary insider sales. Overall, the evidence indicates that executives can use these hedging instruments to significantly alter their effective ownership positions in the firm.

1. Introduction

In recent years there has been a dramatic increase in the development, sophistication, and...