Whether information asymmetry among investors affects the cost of capital is an important issue in the theoretical (e.g., Diamond and Verrecchia 1991; Easley and O’Hara 2004; Hughes et al. 2007) and empirical literature (e.g., Brennan and Subrahmanyam 1996; Easley et al. 2002; Duarte and Young 2009; Mohanram and Rajgopal 2009). In this paper, we study the role of competition among informed investors on the pricing of information asymmetry. Our key finding is that the pricing of information asymmetry decreases when there is more competition among informed investors. This finding is important because it suggests that in the presence of information asymmetry, more competition among informed investors can lower the cost of capital. Further, as we describe below, it has implications for a large literature that investigates the pricing of information quality (e.g., Botosan 1997; Leuz and Verrecchia 2000; Francis et al. 2004, 2005).
The intuition for our hypothesis that the pricing of information asymmetry decreases in competition among informed investors is briefly described as follows (we describe related theories and formally develop our hypothesis in Section 2). Theories on investor competition show that more competition among informed investors results in private information being incorporated into prices more rapidly, i.e., more competition makes prices more efficient (Foster and Viswanathan 1993, 1996; Holden and Subrahmanyam 1992, 1994). We argue that competition among informed investors can then affect the pricing of information asymmetry due to two reasons: (i) it could reduce trading costs arising from price protection by market makers against information asymmetry (Kyle 1985; Admati and Pfleiderer 1988; Diamond and Verrecchia 1991), and (ii) it could reduce the information risk uninformed investors bear when trading against informed investors (Easley and O’Hara 2004).
To measure competition among informed investors, we follow prior literature and consider institutional investors as informed investors (Arbel and Strebel 1983; Sias and Starks 1997; Bartov et al. 2000; Jiambalvo et al. 2002). Using data on total institutional investor ownership for each firm, we construct measures of competition based on (i) the number of total institutional investors, (ii) the percentage of outstanding shares held by total institutional investors, and (iii) a Herfindahl index of competition that captures both the level and the distribution of total institutional ownership. Further, recognizing that transient institutional investors (compared to quasi indexers and dedicated institutional investors) are the ones most likely to trade on information (Bushee 1998; Ke and Petroni 2004; Ke and Ramalingegowda 2005), we also construct analogous measures using data on transient institutional investor ownership.
To measure information asymmetry, we use the information asymmetry component of bid-ask spreads and the probability of informed trading (PIN) based on decomposition models developed by Glosten and Harris (1988) and Duarte and Young (2009), respectively. We include the non-information asymmetry components of spreads and PIN as control variables in our empirical analyses to increase the confidence that our findings are driven by information asymmetry. In untabulated analyses, we find that our inferences are unchanged if we use total spreads and PIN.
To examine the role of competition among informed investors in the pricing of information asymmetry, we use standard asset pricing regressions. We find significant evidence that the pricing of information asymmetry decreases in the extent of competition among informed investors. For instance, the difference in the pricing of the information asymmetry component of spread between the most competitive quintile of firms and the least competitive quintile ranges from 0.70% to 1.23% per month, depending on the competition measure used. The results with the information asymmetry component of PIN are in the same direction, although the economic significance is smaller. Specifically, the differential pricing of information asymmetry across competition among informed investors ranges from 0.22% to 0.25% per month.
In further analyses, we find that the evidence for the differential pricing of information asymmetry conditional on competition is the strongest for competition among transient investors and the weakest (and often insignificant) for competition among dedicated investors. This evidence is consistent with our conjecture that competition among investors who trade actively on information (compared to competition among investors who do not trade actively on information) is likely to have a greater effect in mitigating the pricing of information asymmetry. To address concerns that our measures of competition might be capturing broader aspects of the trading environment that are not related to information asymmetry, we also run tests that control for the cross-sectional variation in the broader trading environment. The results from these tests indicate that the differential pricing of information asymmetry conditional on competition is robust to controlling for share turnover, trading volume, and return volatility.
Finally, we examine whether investor competition influences the pricing of information quality. This literature argues that information quality is priced because poor information quality is associated with higher information asymmetry and information asymmetry is priced (e.g., Botosan 1997; Francis et al. 2004, 2005). To measure information quality, we use accruals quality and earnings smoothness because these measures have been recently used to examine the pricing of information quality (Francis et al., 2004, 2005; Core et al. 2008; McInnis 2009). We also use annual report readability (FOG) developed by Li (2008) as another measure of information quality. We find consistent evidence that the pricing of information quality decreases when there is more competition among informed investors. This result adds support to the argument that one reason that information quality is priced is because of information asymmetry.
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