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Liquidity Changes Associated with Open Market Repurchases

Author

Listed:
  • Ajai K. Singh
  • Mir A. Zaman
  • Chandrasekhar Krishnamurti

Abstract

Before the tax-law changes of 1986, common stock repurchases received favorable tax treatment relative to cash dividends, yet more than 80% of the New York Stock Exchange-listed firms did not use repurchases for distributing value to their stockholders. Prior research suggests a possible resolution of the puzzle by examining the effect of open market repurchases on the liquidity of the firms' stocks. The liquidity of the stock as measured by bid-ask spread may be affected by stock repurchases in any one or all of the following ways. First, when management undertakes to reacquire the firm's shares in the open market they are, in effect, competing with the market makers of the stock. This open market repurchase activity, in the absence of information asymmetry, should result in greater liquidity or lower bid-ask spread. Second, a direct consequence of open market repurchase announcements may be increased trading in the secondary market. Increased trading volume makes it easier for the market maker to reverse his position in the stock. Therefore, the inventory holding cost component of bid-ask spread should decline upon announcements of open market repurchases. A decline in the bid-ask spread would be consistent with this explanation. Third, prior research suggests that open market repurchase announcements are associated with increased trading by informed traders in the secondary market for the firm's stock. Informed traders trade with market makers only at favorable prices. Hence, the adverse selection component of the bid-ask spread should increase in the post-announcement period. This information-asymmetry- based explanation predicts increased bid-ask spreads following announcements of open market repurchases. However, it should be noted that an asymmetric-information-based explanation does not necessarily imply that other market participants face the informed traders in all trades at all times. Specifically, the likelihood of trading with an informed trader is greater when stock prices are lower rather than higher. Also, repurchases only involve buying and not selling by informed traders. Hence, the risk of trading against the informed trader is much less.

Suggested Citation

  • Ajai K. Singh & Mir A. Zaman & Chandrasekhar Krishnamurti, 1994. "Liquidity Changes Associated with Open Market Repurchases," Financial Management, Financial Management Association, vol. 23(1), Spring.
  • Handle: RePEc:fma:fmanag:singh94
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    Citations

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    Cited by:

    1. Ginglinger, Edith & Hamon, Jacques, 2007. "Actual share repurchases, timing and liquidity," Journal of Banking & Finance, Elsevier, vol. 31(3), pages 915-938, March.
    2. Manoj Kulchania, 2013. "Market Micrsotructure Changes Around Accelerated Share Repurchase Announcements," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 36(1), pages 91-114, January.
    3. Dennis Y. Chung & Dušan Isakov & Christophe Pérignon, 2005. "Repurchasing Shares on a Second Trading Line," FSES Working Papers 391, Faculty of Economics and Social Sciences, University of Freiburg/Fribourg Switzerland.
    4. Brockman, Paul & Chung, Dennis Y., 2001. "Managerial timing and corporate liquidity: *1: evidence from actual share repurchases," Journal of Financial Economics, Elsevier, vol. 61(3), pages 417-448, September.
    5. Kothare, Meeta, 1997. "The effects of equity issues on ownership structure and stock liquidity: A comparison of rights and public offerings," Journal of Financial Economics, Elsevier, vol. 43(1), pages 131-148, January.
    6. repec:dau:papers:123456789/1748 is not listed on IDEAS
    7. Brockman, Paul & Howe, John S. & Mortal, Sandra, 2008. "Stock market liquidity and the decision to repurchase," Journal of Corporate Finance, Elsevier, vol. 14(4), pages 446-459, September.
    8. Cheng, Louis & Firth, Michael & Leung, T.Y. & Rui, Oliver, 2006. "The effects of insider trading on liquidity," Pacific-Basin Finance Journal, Elsevier, vol. 14(5), pages 467-483, November.
    9. De Cesari, Amedeo & Espenlaub, Susanne & Khurshed, Arif, 2011. "Stock repurchases and treasury share sales: Do they stabilize price and enhance liquidity?," Journal of Corporate Finance, Elsevier, vol. 17(5), pages 1558-1579.
    10. Craig W. Holden & Stacey Jacobsen & Avanidhar Subrahmanyam, 2014. "The Empirical Analysis of Liquidity," Foundations and Trends(R) in Finance, now publishers, vol. 8(4), pages 263-365, December.
    11. Pierre Collin-Dufresne & Vyacheslav Fos, 2012. "Do prices reveal the presence of informed trading?," NBER Working Papers 18452, National Bureau of Economic Research, Inc.

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