junk_bond - Information-Based Trading in the Junk Bond...

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Information-Based Trading in the Junk Bond Market Xing Zhou Department of Applied Economics and Management Cornell University Abstract Taking advantage of a unique corporate bond transaction dataset from the National Association of Securities Dealers (NASD), this paper investigates whether information-based trading takes place in the high-yield corporate bond market, and how firm-specific information flow across related securities, including stocks, options and corporate bonds. Differing from previous studies, I find that current corporate bond returns have explanatory power for future stock price changes. This implies that informed investors do trade in the corporate bond market, and both the stock market and the corporate bond market serve important roles in disseminating new information. The option market, however, contains valuable information about future movements in both stocks and corporate bonds, and these relations are unidirectional, suggesting that the option market is a preferred venue for informed trading. Furthermore, there is strong evidence that informed trading in the option market is distributed across different strike prices, with at-the-money options attracting investors who posses mild firm-specific information, and deep out-of-the-money options catching the attention of those who obtain extreme information. JEL Classification: G14 Key-words: Firm Specific Information, Information-based Trading, Information-risk Premium, Insider Trading, Junk Bonds, Market Microstructure, Price Discovery. Department of Applied Economics and Management, Cornell University, 253 Warren Hall, Ithaca NY, 14853. Phone: (607)351-8374; Email: xz57@cornell.edu . I thank NASD for help with the data. The views expressed herein are solely those of the author and not those of any other person or entity, including NASD. I thank Hazem Daouk, Maureen O’Hara, David Easley and Yongmiao Hong for helpful comments and discussions. I also thank Vidhi Chhaochharia, David Ng, Michael Piwowar, and Xiaoyan Zhang for their useful suggestions. Any errors are my own.
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1 1. Introduction Since 1934, when the United States Congress enacted the Securities Exchange Act, the stock and the options markets have been under intense scrutiny for potential abuse of material nonpublic information. However, information-based trading also seems to be taking place in the corporate bond market, as investigations by the Securities and Exchange Commission (SEC) and the U.S. Attorney’s Office have revealed the occurrence of insider trading and price manipulation in the junk bond 1 market by the “king of junk bonds”— Michael Milken. In 1989, James Dahl, an employee of Milken's junk bond department, swore before a grand jury that Milken advised him to buy up Caesar’s World bonds from their own customers on the day when Milken made a presentation to Caesar’s World on how to handle their finance, i.e., a sales pitch. In 1990, Michael Milken pleaded guilty to six felony counts in connection with
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This note was uploaded on 12/08/2011 for the course CIS 625 taught by Professor Michaelkearns during the Spring '12 term at Pennsylvania State University, University Park.

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junk_bond - Information-Based Trading in the Junk Bond...

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