Since investors cannot predict the degree of share disposals at lockup expiration with complete certainty, we have thus far considered the “informative selling hypothesis” and the “portfolio diversification hypothesis” in various settings to assess specific characteristics that impact investors’ motivation for selling shares at lockup expiration. Another possible theory to explain the selling behaviour of insiders is the “disposition effect” (Chen et al., 2012). This concept was originally popularized by Shefrin and Statman (1985) who elaborated upon the implications from the theoretical outlook of Kahneman and Tversky (1979). The disposition effect claims that investors tend to realize successful investments too quickly and keep unsuccessful investments in their portfolio for too long (Chen et al., 2012).
In a lockup context, this logic suggests that firms with a positive price ramp prior to lockup expiration will experience a high degree of share disposals by insiders when their lockups expire. A price ramp17 reflects a series of consecutive price movements in the same direction and is often analysed to infer the momentum of stock price movements. Hence, the greater the momentum (i.e. larger price run-up) the more likely it is that insiders will dispose of their shares at lockup expiration.
Due to this increased probability of insider selling at lockup expiration, it becomes vital to consider how the stock price will react according to investor beliefs. The study of Chen et al. (2012) proves that insiders are more likely to be net sellers at lockup expiration when the stock price has undergone a large price run-up during the 30 trading days prior to expiration. One can argue that consecutive increases in a stock price may
17 A positive ramp will also be referred to as a price run-up or a positive price-run. Hence, a negative price ramp is also referred to as a price run-down or a negative price-run.
31 overweigh investors’ portfolios in favour of the stock, thus providing a selling-incentive to rebalance their portfolio. It can therefore be suggested that the disposition effect is comparable to the implications from the portfolio diversification hypothesis. Ofek and Richardson (2000) also attribute price run-up to the portfolio diversification hypothesis, as they argue that a large price run-up will make investors reconsider their portfolio composition and diversification needs. Furthermore, this is also observed by Ahmad et al. (2017) when assessing the UK market, where they conclude that insiders (and more specifically, directors) follow a contrarian strategy by selling their shares after a significant increase in share price.
Field and Hanka (2001) incorporate a variable for a stock’s price run-up in their analysis on abnormal returns at lockup expiration. They hypothesize that investors are more eager to sell their shares when the stock price has risen over a long period of time. However, they do not find the run-up to be a significant predictor of abnormal returns, thus implying that share disposals will not be unexpected.
However, this may also be due to the fact that the authors attribute the price run-up to two opposing effects.
Firstly, they emphasize that investors’ willingness to perform a share sell-down may stem from overconfident intentions to profit off momentum. In line with the theory on overconfidence (Chen et al., 2002; Kahl et al., 2003; Doran et al., 2014), this suggests a greater propensity for unexpected share disposals and thus an abnormally negative price reaction at lockup expiration. Secondly, Field and Hanka (2001) assume that positive price-runs reflect a firm’s high quality. From an investor perspective, this notion implies a diminishing magnitude of the potential supply shock and informational asymmetry that can prevail at the actual lockup expiration, thus suggesting a less negative price reaction.
Furthermore, this view can be extended by the concept of information momentum, where stocks with large price run-ups will attract more investor attention, which implies that investors will have a greater likelihood of determining the firm’s true value (Haggard and Xi, 2017). Hence, a potentially lower magnitude of share disposals and a greater likelihood of value realization will cause an absence of abnormal price reactions at lockup expiration.
Positive price-runs can also be related to overvalued stocks for which it is argued that IPOs cannot sustain an inflated value over a longer period. The share prices of such stocks must therefore conform to their true value in the IPO aftermarket. Haggard and Xi (2017) emphasize that the duration of a typical lockup is a reasonable period for such value realization to take place. Consequently, if a stock’s price run-up proxies the degree of investors’ price realization, one would expect less likelihood of abnormal price reactions at lockup expiration (ceteris paribus)18.
When testing their hypotheses empirically, Haggard and Xi (2017) observe that larger price run-ups prior to the event window are significantly associated with a more negative CAR at lockup expiration. This result is
18 Assuming that IPOs are (on average) priced at their fair value.
32 based on 3,328 US IPOs during the period from 1993 to 2014. Due to this significantly negative relationship, Haggard and Xi (2017) revisit their hypothesized outcome that large price run-ups imply a greater extent of value realization among investors, thus a diminishing likelihood of abnormal price reactions at lockup expiration. This initial hypothesis assumes that IPOs are on average priced at their fair value. Hence, although some stocks will be deemed either over- or undervalued, the overall effect of value realization will on average suggest an absence of abnormal price reactions. Instead, when revisiting this initial hypothesis, they conclusively refer to Purnanandam and Swaminathan (2004) who prove that median IPOs are overvalued when comparing to industry peers. Substantiated by this finding, Haggard and Xi (2017) suppose that when stocks with large price run-ups attract investors’ attention, there will be a greater likelihood of investors determining that such stocks in fact are overvalued. When restrictions are relaxed at lockup expiration, the authors therefore suppose that stocks with large price run-ups are more likely to unexpectedly be identified as overvalued, which would be proven by a more negative price reaction at lockup expiration (ceteris paribus)19.
Although Haggard and Xi (2017) find empirical evidence of a significantly negative relationship between price run-up and CAR at lockup expiration, we acknowledge that a substantial body of previous research argues in favour of a or positive relationship between the two variables. We assert great importance in assessing the impact that stock price run-up has on abnormal returns at lockup expiration. We have constructed the price-run hypothesis as following:
Hypothesis 4C: We expect that a positive price ramp during the lockup period has a positive relationship with cumulative abnormal return at lockup expiration
4 Methodology
In the following section, we will outline the methods that have been applied throughout the course of this thesis. Firstly, the overarching research philosophy and the appertaining research approach are explained and put into the context of the research objective. Secondly, the sample selection and data collection procedures are briefly outlined. Thirdly, the event study approach is determined for analysing abnormal returns in conjunction with Hypothesis 1. Lastly, the construction of variables for the cross-sectional analysis is described and subsequently followed by a walkthrough of the statistical framework for the cross-sectional analysis.
19 This conclusive inference of Haggard and Xi (2017) assumes that the median IPO is overvalued (Purnanandam and Swaminathan, 2014). It is thus suggested for further research to investigate whether this notion holds on average.
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