Trading in the Presence of Short-Lived Private Information: Evidence from Analyst Recommendation Changes

Abstract

We study how short-lived private information affects trading strategies and liquidity provision. Our empirical identification rests on information acquisition before analyst recommendations are publically announced. Consistent with theory, institutional investors who are likely to possess short-lived private information on average “buy the rumor and sell the news,” buying before analyst upgrades and selling when upgrades are announced. When we go beyond existing theory, we find that different classes of informed institutions differ in their profit-taking patterns, reflecting variations in their trading horizons and motives. The returns to holding private information are economically large. Individuals, who are unlikely to be informed early, buy on upgrade announcements but not before. Institutions that are not attentive to firm-specific news appear to suffer from a winner’s curse, emerging as de-facto liquidity providers to better-informed institutions. Placebo tests confirm that these trading patterns are unique to situations in which some investors have a short-lived informational advantage.