Journal of Banking & Finance 30 (2006) 21992214 www.elsevier.

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Volatility eects of institutional trading in foreign stocks

Chiraphol N. Chiyachantana a, Pankaj K. Jain b, Christine Jiang b, Robert A. Wood b,*
a

Lee Kong Chian School of Business, Singapore Management University, Singapore 178899, Singapore b Fogelman College of Business, University of Memphis, Memphis, TN 38152, USA Received 29 October 2004; accepted 21 June 2005 Available online 6 December 2005

Abstract This paper examines the impact of institutional trades on volatility in international stocks across 43 countries. There is a temporary volatility spike during the trade execution period, merely reecting the price impact costs faced by the institutions. Cross sectional regressions suggest that trade imbalances, enforcement of insider trading laws, stock prices, and an emerging market classication are positively associated with temporary volatility increases whereas the presence of market makers and better shareholders rights dampen such increases. In the long term, institutional trades do not destabilize markets as the levels of volatility after their trades are almost identical to their pre-decision levels. 2005 Elsevier B.V. All rights reserved.
JEL classication: G14; G15 Keywords: Institutional trading; Volatility; International investments

1. Introduction Institutional trading in global stock markets often takes the form of large blocks of shares such that a single order from institutions often exceeds the average daily volume
Corresponding author. Tel.: +1 901 678 2610; fax: +1 901 678 0839. E-mail addresses: chiraphol@smu.edu.sg (C.N. Chiyachantana), pjain@memphis.edu (P.K. Jain), cjiang@ memphis.edu (C. Jiang), rawood@pobox.com (R.A. Wood). 0378-4266/$ - see front matter 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankn.2005.06.001
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in a given stock. Consequently, the trading decisions of these market movers and shakers may have a signicant impact on stock prices and volatility. In smaller markets, institutional trades can potentially destabilize the markets if they cause excessive volatility.1 Volatility is a variable of key interest in nancial economics. Higher volatility can increase risk premium, which makes nancial capital more costly for rms (see French et al. (1987)). Volatility is also a key determinant of option prices. It is a crucial input for the analysis performed by traders, investors, risk managers, regulators, and researchers who are interested in managing risk or maintaining market stability. This paper examines stock price volatility around institutional decisions, orders, and trades in international stocks across 43 countries using a proprietary dataset from the Plexus Group. With recent availability of data, the literature on international institutional trading is burgeoning. Perold and Sirri (1998), Domowitz et al. (2001, 2002) and Chiyachantana et al. (2004) use data on actual international institutional trades for a large number of countries. However, the focus of all those studies is on transaction costs. To the best of our knowledge, our paper is the rst study that looks at volatility around actual institutional decisions and trades across a large number of foreign markets. Studies using US data suggest that institutional trades increase volatility, which can potentially indicate destabilization (Aggarwal and Chen, 1990). In addition, Dornbusch and Park (1995), Radelet and Sachs (1998), and Stiglitz (1998) suggest that these concerns are elevated when large institutional investors operate in smaller foreign markets. The claim is that foreign investors pursue strategies that make stock prices overreact to the fundamentals and therefore bring instability to local markets through excessive volatility. However, Choe et al. (1999) refute these claims by reporting that there is little evidence of a persistent sharp increase in volatility following the Koreas economic crisis in 1997. Bekaert and Harvey (2000) also suggest that volatility in emerging markets decreases after markets are opened to foreign investors. These studies follow a macro-approach by analyzing volatility changes around liberalization dates. Our dataset allows us to conduct a much ner micro-analysis to address this debate by examining the impact of the actual institutional decisions and trades on volatility. We examine the temporary volatility changes in the institutional trading period as well as the long lasting volatility eects in the post-transaction period. Moreover, we study both developed and emerging markets to see if the volatility dynamics dier between the two. Emerging markets lack the depth to sustain extreme buying or selling pressures. Foreign speculators are often accused of causing excess volatility in the emerging markets. Institutional trades have varying magnitudes and aggressiveness. Trading imbalances have been used in the literature to gauge the overall buying or selling pressure on a stock. Given that volatility might be aected by the intensity of institutional positions, we are interested in exploring the relation between trading imbalances and change in volatility. Thus, in our cross sectional regressions, we use change in volatility around institutional decisions and trades as the dependent variable and institutional trading imbalance as the key explanatory variable. We also include as control variables the strictness in the enforcement of insider trading laws, short-selling feasibility, the presence of market makers in a market, an emerging markets dummy, price level of stock, index of shareholders

Stiglitz (1998) cautions that developing countries are more vulnerable to vacillations in international ows than ever before.

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rights, and change in market volatility. We now briey discuss the predicted eects of these variables on volatility. The traditional view on the impact of insider trading is that it impairs liquidity which in turn increases volatility. The argument used to support this view is that insider trading exacerbates information asymmetry and losses to informed traders. In contrast, Bhattacharya et al. (2000) show that in a country with no enforcement of insider trading laws, prices do not react to news announcements because prices had already been moved by insider-trading before the announcement. Therefore, the volatility eects of institutional trading will be less important if hidden factors and insider-trading dominate the pricediscovery process. In a strong form ecient market, prices are said to incorporate all information including that possessed by insiders. Empirical evidence on the matter is also presented in Cao et al. (2004) who nd that insider trading after IPO lock-up expirations actually improves liquidity suggesting that expected losses to insiders are minor compared to other costs of trading. To test these competing hypotheses in the context of volatility, we obtain information on enforcement of insider trading laws in each country from Bhattacharya and Daouk (2002) who document that prohibiting insider trading helps improve liquidity and lower cost of equity. The ability of investors to short sell in a market might impact the change in volatility and the extent to which the trades are destabilizing. Charoenrook and Daouk (2003) report that the ability to short sell diers across countries. In countries in which short selling is feasible, investors are able to move stock prices more quickly to their fundamentally appropriate values. Specically, hot money might be less able to destabilize a market with bullish momentum trading if arbitragers are able to counter them with short sales. Market design features could also have an eect on how institutional trades impact prices and volatility. In particular, the presence of designated market makers helps to reduce volatility during the trading period because of their armative obligation to provide liquidity and to ensure smooth price movements from trade to trade. Emerging markets are shown to possess higher volatility by Domowitz et al. (2001). We obtain the index of shareholders rights across countries from La Porta et al. (1998) who show that better rights result in more vibrant markets. This can dampen the volatility shocks. Finally, it is important to control for market wide volatility because it inevitably aects the total volatility of individual stocks whereas we are mainly interested in the component of volatility due to actual institutional trading. Several studies (e.g. Dornbusch and Park, 1995) show that the trades of foreign investors are related to past returns. They buy (sell) when prices have increased (fallen). This practice is called positive feedback trading, or momentum trading. Theoretical models have shown that momentum trading can exert a destabilizing inuence on the stock market by pushing prices away from fundamentals (De Long et al., 1990). Specically, momentum purchases can make money by buying after price increases regardless of whether the price increases are rational or not. Momentum traders can keep prices increasing long enough to force fundamental traders to liquidate their positions prematurely due to margin requirements. Similarly, momentum sells cause prices to keep falling. Momentum trading, however, does not always destabilize the market. Investors trading on fundamentals may be suciently powerful in the markets to prevent prices from moving away from fundamental values. In addition, momentum traders may be trading in response to information about fundamentals, so that their trading does not drive prices away from fundamentals. Empirical research is therefore required to settle the issue of whether

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momentum trades are destabilizing. Our data oer us a unique opportunity to examine this important issue across a wide range of foreign markets. We analyze volatility for several intervals around institutional decisions and trades, and nd higher volatility only during a brief period when institutions are making trades. We conjecture that this temporary rise in volatility is not harmful for the markets but merely reects the price impact costs faced by the institutions themselves. Our cross sectional regressions suggest that intensity of institutional trading imbalances, strictness in the enforcement of insider trading laws, higher prices, and emerging markets classication are positively associated with temporary increases in volatility whereas better shareholders rights, and the presence of market makers dampen such increases. Feasibility of short selling in foreign markets lowers volatility on stocks in which institutions carry buy imbalances. More importantly, when analyzing post-trade volatility, we nd no evidence that any of these variables have any permanent impact on volatility. There is no evidence that institutions momentum trading brings higher volatility after the trades are completed. Furthermore, although volatilities in emerging markets are generally much higher, they also revert back to their pre-decision levels after the temporary rise at the time of bloc trade execution. The remainder of our paper is organized as follows. Section 2 contains discussions on data sources and research design. Section 3 presents our main empirical results, and Section 4 presents results on robustness checks. Section 5 has concluding remarks. 2. Data sources and research design We obtain a sample of institutional trading in stocks of 43 countries from the Plexus Group, an independent consulting rm for institutional clients. The data include information on institutional decisions about stocks traded, direction of trade (buy or sell), quantity of shares desired, value-weighted average stock prices on and before decision date, dates of release of orders from institutional clients to trading desks, price at the time of release, number of shares released, code number of broker(s) used to ll the order, transaction price, quantity of shares traded, execution date, commissions charged, and the market capitalization of the stock. Information about stock prices 15 days before and 25 days after an institutional decision is also provided in the Plexus dataset. We verify the accuracy of data on the individual stock returns and volumes by cross-checking a representative sample of stocks in Datastream International and Yahoo Finance. To maintain the integrity of the data and lter out possible record errors, we eliminate observations with missing prices or order quantities. In addition, following the approach of Keim and Madhavan (1995, 1997), we exclude orders or transactions of less than 100 shares, orders for stocks trading under $1.00, and orders that took longer than 21 calendar days to complete. Finally, we use Datastream International stock market indices for the 43 countries from which the stocks in the sample originate. These indices help us to measure market volatility and excess returns relative to local market indices. Table 1 presents the descriptive statistics for our sample of institutional trading in 43 countries in the rst three quarters of 2001. Panel A provides overall statistics of the sample. Panel B categorizes the sample characteristics at the decision and transaction levels. In all, 6033 rms are analyzed. Their average market capitalization is 2.04 billion dollars. The average daily return volatility across all sample stocks is 8.38 basis points. The institutions

C.N. Chiyachantana et al. / Journal of Banking & Finance 30 (2006) 21992214 Table 1 Descriptive statistics A. Sample characteristics Number of countries Number of securities Average market cap (million $) Volume-weighted trade price ($) Average daily return volatility (basis point) B. Decision/transaction characteristics Total number of decisions Total trading volume (millions of shares) Total dollar volume (million $) $ Purchase/$ total (dollar value) Number of shares per decision Dollar volume per decision ($) Average number of transaction per decision 43 6033 2038 11.62 8.38 276,947 23,037 213,065 50.39% 86,569 797,434 1.63

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This table presents institutional trading characteristics in 43 countries in the rst three quarters of 2001. Panel A provides overall statistics of the sample. Panel B categorizes the sample characteristics at the decision and transaction levels.

Pre-decision period

Decision date

Last transaction date

Post-transaction period

|_____________________|************************|############################# d-15 d t t+25

Fig. 1. Time-line of pre-decision, decision, trade execution, and post-transaction periods This gure shows the event dates on a time line. The pre-decision period is between d 15 and d 1. The period marked with asterisks is the transaction period. The post-transaction period is indicated by hashes.

made 276,947 decisions which were approximately evenly split between buys and sells. The average institutional decision involves 86,569 shares or $797,434. These blocs are divided into 1.63 trades per decision. Fig. 1 shows the research design in terms of institutional decision date (d) and the date of last transaction in a decision (t) on a time line. We construct a pre-decision period that starts from 15 days before the decision and ends a day before the decision. Next, we have a transaction period from d to t. Finally, the post-transaction period starts immediately after the last transaction in a decision package and ends 25 days after the last transaction in that decision package. In our analysis, we also examine shorter time horizons within the pre and post-decision periods such as 1 day before decision to decision date or from last transaction date to 2 days after the last transaction. We compute volatility around institutional trades using the methodology similar to French et al. (1987). Volatility is calculated by squaring the dierences of logarithms of successive daily prices, p.2 Since our intervals are of dierent lengths, we then divide the sum of changes in daily return squared by the number of days included in an interval

2 French et al. (1987) also include another term which is twice the sum of products of the adjacent returns to account for the rst-order autocorrelation of returns caused by non-synchronous trading. Our sample mainly comprises active stocks and does not suer from this problem.

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to arrive at daily volatility.3 Thus, average volatility for security j over an interval of n days Vj is calculated as n X logpj;t logpj;t1 2 =n. 1 Vj
t1

An important component of the volatility on individual stocks raw return is the impact of the overall market. Specically, volatility of raw returns can be higher simply because volatility is higher in the overall market. To further delineate the change in volatility caused exclusively by institutional trades, we also compute volatility for stocks after adjusting for the market wide returns m. The market adjusted return volatility Vmj is n X flogpj;t logpj;t1 logmt logmt1 g2 =n. 2 V mj
t1

3. Empirical results We report daily volatility based on both raw returns and market adjusted returns, for several pre-decision intervals (namely, 2-day, 5-day, and 15-day) before decisions, the time between a decision and corresponding transactions,4 and several post transaction intervals (2-day, 5-day, and 15-day, and 25-day) in Table 2. With respect to volatility based on raw returns reported in Panel A, we nd that for all the decisions, volatilities are rather stable for the three intervals before decisions, ranging from 7.36 to 7.72 basis points. Volatility is signicantly higher between days d and t at 12.78 basis points, suggesting that institutional decisions are associated with higher volatility during the trade-execution period. Interestingly, once all the transactions in a decision are completed, the post-transaction volatility quickly reverts back to the level prior to institutions decision. Compared to the volatility in interval (d 15, d) is used as the pre-decision benchmark, post-transaction volatility extending to 25 days after day t is actually slightly lower. Next, we examine if the degree of volatility-change is aected by intensity of institutional trade imbalances. We measure the daily institutional trading imbalance for each stock by calculating the dierence between the share volumes of buy and sell decisions on day i. Absolute imbalancei = Abs(total shares in buy decisions total shares in sell decisions),
 Absolute imbalancei ; Buy imbalancei 0;  Absolute imbalancei ; Sell imbalancei 0;  if total shares in buysi > total shares in sellsi ; and otherwise;  if total shares in buysi < total shares in sellsi otherwise.

When the impact of institutional trades on volatility is examined over time in these subsamples partitioned by imbalances, the basic message remains the same. Institutional trades cause volatility to rise temporarily, yet, once the transactions are completed, volaSee Kim and Rhee (1997) which follows a similar methodology. The average duration of institutional decisions for Plexus clients in 2001 is a little over 2 days, as reported in Chiyachantana et al. (2004).
4 3

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(d 15, d) (d 5, d) (d 2, d) (d, t) Panel A. Average volatility on individual stocks All decisions 7.36 7.53 Imbalances Buy Sell Dierence (buy sell) Firm size Large Med Small Dierence (large small) Developed versus emerging Developed Emerging Dierence (dev. emerg.) 7.38 7.34 0.04 6.79 8.62 11.06 4.27 7.27 8.21 0.94 7.51* 7.55 0.03 7.72*** 7.76** 7.68** 0.08 12.78***

(t, t + 2) (t, t + 5) (t, t + 15) (t, t + 25) 7.88*** 7.69*** 7.40 7.10

12.78*** 7.77** 7.57 7.28 6.99 12.78*** 8.01** 7.85* 7.56 7.24 0.00 0.24 0.28 0.28 0.25 11.44*** 7.30*** 7.14* 6.79 6.51 15.87*** 9.20** 8.89* 8.79* 8.46 20.83*** 11.35 11.38 11.12 10.76 9.39 4.05 4.24 4.33 4.25 12.27*** 7.79** 7.62*** 7.32 7.02 17.44*** 8.64 8.36 8.15 7.87 5.17 0.85 0.74 0.83 0.85 12.84*** 12.72*** 0.12 7.96*** 7.79 0.18 7.73*** 7.65 0.08 7.42 7.38 0.04 7.13 7.07 0.06

6.93 7.04*** 8.82* 9.22** 11.43 12.16 4.50 5.12 7.45 7.67*** 8.23 8.18* 0.78 0.51 7.62 7.43 0.19 7.89** 7.55** 0.35

Momentum versus contrarian trading Momentum 7.41 Contrarians 7.31 Dierence (mom. cont.) 0.10

Panel B. Average stock return volatility after market adjustment All decisions 6.96 7.06 7.22* 11.50*** Imbalances Buy Sell Dierence (buy sell) Firm size Large Med Small Dierence (large small) Developed versus emerging Developed Emerging Dierence (dev. emerg.) 6.96 6.95 0.01 6.18 8.88 11.72 5.54 6.86 7.90 1.04 7.02 7.10 0.07 6.24 9.07 12.18 5.93 7.16** 7.31 0.15 6.35 9.39 12.71 6.37

7.26*

7.12

6.96 6.88 7.05 0.17

6.72 6.65 6.80 0.15

11.46*** 7.22** 7.05* 11.55*** 7.30 7.21 0.09 0.08 0.16 9.90*** 6.44 15.50*** 9.31 21.31*** 12.22 11.41 5.78

6.35 6.14 5.92 9.06 9.06 8.74 11.91 11.83 11.45 5.56 5.70 5.53

7.17*** 6.97* 7.87 7.76 0.89 0.59 7.07 7.05 0.02 7.24 7.21 0.03

11.11*** 7.20* 7.05 6.87 6.62 15.15*** 7.78 7.77 7.79 7.58 4.04 0.58 0.72 0.92 0.95 11.58*** 7.24** 11.43*** 7.27 0.15 0.02 7.12* 7.13 0.00 6.96 6.96 0.00 6.72 6.71 0.01

Momentum versus contrarian trading Momentum 6.97 Contrarians 6.95 Dierence (mom. cont.) 0.02

This table reports average daily volatility for several intervals around institutional decisions and trades. The numbers reported in the table are volatility in basis points. d is the decision date and t is the date that the last transaction in the decision is completed. Estimates of daily volatility are reported for all decisions, buy versus sell imbalances, decisions across rm size, decisions in developed versus in emerging markets, and lastly momentum versus contrarian trades. Volatility in trade and post-transaction periods are compared with that of pre-decision period (d 15, d) and asterisks next to the numbers show statistically signicant dierence in volatilities. ***, ** and * indicate statistical signicance at 1% , 5% and 10% levels, respectively. The last row in each partition reports the dierence in volatility across groups for a given time interval. , , and indicate statistical signicance at 1% , 5% and 10% levels, respectively.

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tility reverts back to normal levels. In some sample partitions, post-trade volatility is in fact slightly lower than pre-decision volatility. Another dimension that is of interest to us is the dierence in volatility eects of institutional buy imbalances and sell imbalances. To that end, we present an additional row which shows the cross-sectional dierence between volatility of the two groups, and statistical signicance is indicated by . Interestingly, although the pre-institutional trade volatility is similar, the statistics in the post-transaction intervals show that those stocks in which institutions accumulate sell imbalances have higher volatility. We also partition our sample based on market capitalization. We continue to observe that institutional trades do not cause a long lasting increase in volatility in the time-series even for small rms. Yet, as expected in the cross-sectional analysis, volatility is higher for smaller rms, across all intervals. In addition, we examine volatility in developed versus emerging markets. We nd that volatility is higher in emerging markets across all intervals, but the increase in volatility associated with institutions trading is again a temporary phenomenon. Institutions can follow momentum strategies for rational reasons or because of behavioral biases. Investors who pursue portfolio insurance strategies as well as investors with extrapolative expectations are momentum traders. Investors with such strategies are often viewed as destabilizers because their sales in declining markets lead the prices to fall further and their purchases in rising markets increase prices sharply. Besides contributing to the volatility of stock returns, it is argued that such trading leads to destabilizing capital ows, because equity investors rush into countries whose stock markets are booming and ee from countries whose stock markets are falling. We explore the possibility that momentum trades may cause volatility to increase, by dividing our sample into momentum trades versus contrarian trades. This classication is based on the following criteria: Institutional buy is a If pre-decision return is positive If pre-decision return is negative Momentum trade Contrarian trade Institutional sell is a Contrarian trade Momentum trade

where individual stock return is market-adjusted by subtracting the respective local market index return. Institutional buys (sells) in stocks that have outperformed (underperformed) the local markets in a pre-decision period are considered momentum trades. Although the choice of pre-decision period can vary in length, here we choose to classify samples into the categories momentum and contrarian trades conditioned on past 1-day return. This is consistent with Choe et al. (1999) and Chiyachantana et al. (2004) in that institutions trading strategies follow a clearer pattern when conditioned on shorter-term performances. The results of this analysis are at the bottom of Panel A in Table 2. There is no evidence that momentum trades are dierent from contrarian trades in how they aect volatility over time. Both temporarily increase the volatility by similar magnitude, but neither has a long lasting impact on stock volatility. When we examine the cross-sectional dierence in volatility of momentum and contrarian trades for the pre and post-decision intervals, momentum trades appear to have marginally higher volatility. This dierence, however, disappears once we calculate market return adjusted volatility in Panel B.

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To ensure the robustness of our ndings, we also use several other pre-decision intervals (e.g., 2-day, 5-day, and 15-day) to dene momentum and contrarian trades, and our key results are not sensitive to the intervals used to dene trades, and are qualitatively the same as those reported in Table 2. Results are also similar in a robustness check for which momentum and contrarian trades are dened using pre-decision raw returns that are unadjusted for market index changes. Panel B of Table 2 reports volatility on individual stocks traded by institutions after adjusting for market-wide volatility. In general, market-adjusted volatility in Panel B is lower compared with raw-volatility reported in Panel A. In most instances where Panel A was showing an increase in the post-transaction volatility, Panel B does not show any increase. We attach a bigger weight to Panel B because it adjusts for market-wide volatility before testing the impact of institutional trading. In this sense, Panel B reinforces our earlier message that the impact of institutional trades on volatility is merely transitory. After market wide movement is accounted for, institutional trading clearly does not bring a higher volatility in the post-trade period. Next, we compute volatility around institutional trades country-by-country and report the results in Table 3. The overall results on a country-by-country basis are quite similar to those reported in Table 2. There is signicant cross country variation in the volatility of countries in the predecision, trade, and post-transaction periods. Nevertheless, the time-series eects are very similar across countries. There is a temporary spike in volatility of stocks in almost every country in the trading period. However, this increase in volatility is short lived. In the post-transaction period, there is no evidence of increase in volatility of stocks traded by the institutions except for a few countries. In fact, for some countries (for example, Canada, Chile, and Korea, among others) there is an indication of a slight decline in the posttransaction volatility. A more careful analysis is presented in Fig. 2 where we consider each individual day in the sample period instead of considering sub-periods of several days grouped together. There is ample and clear evidence that the spike is an artifact of price impact at the time of trade execution and institutional trading has no lasting eects on stock volatility. The temporary increase in volatility is apparently much sharper for our sample of decisions in emerging markets. One of the competing explanations for the positive association between transitory volatility spike and institutional trading activity is that it is associated with some events or news announcements. The institutional trades might also be in response to the same events or the news announcements. With such endogeneity, the positive association mentioned above could be spurious. However, this type of endogeneity will also make institutional trades more likely on high volatility days in the market. To address the above concern, we present another graph which depicts the relationship between absolute dollar imbalance and volatility.5 Unlike Fig. 2 which is in event time around institutional trades, Fig. 3 is constructed in calendar time. In other words, for Fig. 3, we include every day within our sample period whether or not there is an institutional trade on that day. We calculate the volatility on
5 Future research can address this issue more directly using databases that include all daily news events in all foreign markets. If news arrivals are uniformly distributed across all days, instead of clustering on the days that institutions trade, endogeneity will be completely ruled out.

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Table 3 Volatility around institutional trades by country Country Pre-decision (d 15, d) Argentina Australia Austria Belgium Brazil Canada Chile Colombia Czech Republic Denmark Finland France Germany Greece Hong Kong Hungary India Indonesia Ireland Israel Italy Japan Korea Luxembourg Malaysia Mexico Netherlands New Zealand Norway Pakistan Philippines Poland Portugal Singapore Slovakia South Africa Spain Sweden Switzerland Taiwan Thailand United Kingdom Venezuela 9.08 3.64 3.74 4.27 8.66 8.66 2.18 2.73 7.25 7.32 12.25 7.76 10.06 7.08 5.98 5.08 12.12 6.12 5.26 2.66 4.82 7.34 11.62 2.78 5.67 6.22 7.61 3.30 8.54 3.09 4.71 7.54 4.07 6.60 6.25 6.31 4.58 8.83 6.32 7.32 6.53 7.69 4.13 (d 5, d) 9.68 3.78 3.69 4.61 8.58 8.30 2.81* 2.46 7.93 7.67 12.23 8.03 10.02*** 6.88*** 5.90 4.79 12.77 6.70* 5.51 3.32 5.02 7.60 11.32 4.37 5.98 5.89* 7.94 3.41 8.78* 3.23 5.82 7.81 4.03 7.05** 9.36 6.48 4.69 8.74 6.46 7.62 6.45 7.94 3.20 (d 2, d) 7.83 3.98 3.91 4.73 8.60 8.72 2.72 3.00 8.33 7.90 12.40 8.23*** 10.37** 6.50*** 6.21 4.83 13.12* 5.52 4.98 1.67 5.09*** 7.82 10.86 4.37 6.40 6.36 7.84 3.27* 8.68* 2.04 8.39 7.21 4.29 7.30 14.83 6.54 4.88 9.21 6.47 8.20 6.05** 8.22** 1.74** Trade (d, t) 18.48 6.98*** 8.91*** 8.66** 12.21*** 11.10*** 5.55* 19.10** 16.74** 12.85*** 22.33*** 13.33*** 18.33*** 14.79*** 10.62*** 9.28*** 33.05*** 12.10* 9.14** 10.26 8.70*** 13.22*** 26.61*** 6.82 11.92*** 10.30* 13.89*** 6.86*** 15.74*** 5.06 8.46* 19.95* 7.61*** 14.06*** 9.51 12.02*** 7.41*** 14.76 10.80*** 15.47*** 12.75*** 11.40*** 16.05*
***

Post-transaction (t, t + 2) 10.89 3.87 3.90 4.89 10.07** 8.81* 1.70 3.59 7.03 7.52 12.90 8.62 11.05 6.73 5.83 5.00 13.57 5.55 6.12** 3.48 5.89 7.72** 11.16 3.26 7.41** 7.35 8.30 4.89 8.75 2.34 4.58 8.32 4.50 7.21 12.20* 6.52 4.83 8.50 6.46 8.15* 7.63 8.37** 5.82 (t, t + 5) 11.34 3.67 4.09 4.66 9.42 8.58** 2.17 2.49 6.29 7.88 13.13 8.15 10.76 6.62** 5.76 4.68* 13.65 5.90 6.06 3.67 5.35 7.58** 10.84 2.22 6.20 7.03 8.20 3.86 8.43* 3.60 4.85 9.60 4.17 7.05 12.22 6.27 4.89 8.52 6.36 7.97* 6.76 8.24* 3.25 (t, t + 15) 11.12 3.51 3.88 4.54 8.63 8.17** 1.80 2.77 7.00 7.41 13.20** 7.64 10.34 7.25 5.73 4.56** 14.46 5.89 5.86 4.81 4.75 7.19 10.19** 1.74 5.67 6.48 7.91 3.26 8.41* 2.95 5.33 8.87* 4.02 6.61 9.21 6.12 4.37 8.34 6.26 7.65** 6.02 8.08** 3.21 (t, t + 25) 11.14 3.44 3.60 4.11 8.46 7.91** 1.64** 2.55 7.06 7.12 13.23** 7.22 9.85 7.09** 5.54 4.49* 13.44 6.12 5.69 4.71 4.55 6.96 9.84** 1.75 5.35 6.17 7.52 3.04* 8.03** 2.80 4.82 8.53* 3.87 6.19 12.27 5.95 4.09 8.08 5.89 7.43 6.06 7.70 3.37

This table reports average daily volatility for several intervals around institutional decisions. The numbers reported in the table are volatility in basis points. d is the decision date and t is the date that the last transaction in the decision is completed. Estimates of daily volatility are reported for the 43 countries in our 2001 sample. Volatility in trade and post-transaction periods are compared with that in pre-decision period (d 15, d) and asterisks next to the numbers show statistically signicant dierence in volatilities. ***, ** and * indicate statistical signicance at 1% , 5% and 10% levels, respectively.

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Return Volatility
18.00 Full Sample 16.00 Developed Emerging 14.00

2209

Return Volatility

12.00

10.00

8.00

6.00
-1 5 -1 4 -1 3 -1 2 -1 1 -1 0 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Event Date

Fig. 2. Daily volatility from 15 days before a decision to 25 days after last trade.

Volatility and dollar imbalances in calendar time

4500000 4000000 3500000

Dollar Imbalance

3000000 2500000 2000000 1500000 1000000 500000 0 0.00 Fitted Trend Line

Absolute Dollar imbalance Linear (Absolute Dollar imbalance)

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

Volatility

Fig. 3. Average volatility and absolute dollar imbalances.

each day. Then we sort the days by volatility and plot volatility on x-axis and institutional trades on y-axis. The tted trend line is downward sloping, implying that institutions are not trading heavily on days when volatility is high. Thus, high volatility is not necessarily causing institutional trading. In contrast, in Fig. 2 institutional trading do appear to cause temporary volatility spikes in the (d, t) period. With the combination of these two gures, we have reasons to believe that endogeneity in trading may not be an issue here. Our

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interpretation is that institutional decisions are based on other exogenous factors, not just volatility or events that cause volatility. Yet, in the other direction, institutions do cause temporary spikes in volatility due to their activities. Nevertheless, this increase in volatility is short-lived and reverts to normal levels in the post-transaction period. Finally we estimate the following regression model with changes in volatility as dependent variables, institutional imbalance as the key explanatory variable, and several control variables: DVolatility b0 b1 Imbalance b2 Price b3 Market cap. b4 Change in market volatility b5 Momentum b6 Emerging mkt b7 Short selling feasible b8 Market maker b9 Shareholder right b10 Insider law enforced e; 3 where DVolatility is computed for the trading period as the dierence between average daily volatility during the trading period (d, t) and a benchmark period 15 days before the decision, that is DVolatilitytrade Volatilityd; t Volatilityd 15; d. 4 Price is the stock price in dollars at the time of decision. Market capitalization is computed at stock level in millions of dollars. Institutional trading imbalance for each stock is calculated as the dierence between the share volumes of buy and sell decisions. In one specication labeled as Model 1, we use the absolute value of this imbalance as an explanatory variable. In an alternative specication, labeled as Model 2 buy and sell imbalances are used as two separate explanatory variables to explore the possibility of dierent magnitudes for their regression coecients. Change in market volatility is calculated from the returns on country index over the corresponding period, based on where the stock originates. Momentum is an indicator variable for momentum-motivated trades as discussed earlier in this section. Emerging market is an indicator variable which is assigned a value 0 for developed markets and 1 for emerging markets. We have adopted the Morgan Stanley Capital International classication scheme from their website mscidata.com. Short selling feasible is a dummy variable which takes the value of 1 for countries in which short-selling is legal and feasible to carry out. We experiment with interaction terms between short-sell feasibility and the direction of the imbalances in our regression specication labeled as Model 3. This allows us to test the notion that short sales could make markets more destabilizing on the sell side but could also prevent irrational bubbles on the buy side. We obtain information on feasibility of short sales from Charoenrook and Daouk (2003). A dummy variable to denote the presence of designated market makers in the foreign countries is also included based on information in Jain (2005). Shareholders right is an index generated by La Porta et al. (1998) for dierent countries on a scale from 0 to 5, with 0 representing least rights and 5 representing most rights. Bhattacharya and Daouk (2002) give information in their Table 2 about the date of the rst enforcement of insider trading laws, which we use to determine whether insider trading laws are enforced (dummy = 1) in a country or not (dummy = 0). The results of this regression analysis are presented in Table 4 and are fairly consistent across the three models. A positive and statistically signicant intercept term indicates that average volatility in trading period is higher than that in the benchmark period. Trading imbalances have positive and statistically signicant coecients. This means that sharper

C.N. Chiyachantana et al. / Journal of Banking & Finance 30 (2006) 21992214 Table 4 Regression analysis Variable Intercept Absolute imbalance Buy_imbalance Sell_imbalance Price Market capitalization Change in market volatility Momentum Emerging market Short-sell feasible Buy_imbalance*Shortsell feasible Sell_imbalance*Shortsell feasible Market maker Shareholder rights Insider law enforced Adjusted R-squared Model 1 0.015** 0.015*** Model 2 0.015** 0.014*** 0.015*** 0.043*** 0.022 0.640*** 0.010 0.020*** 0.018***

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Model 3 0.036*** 0.123*** 0.016 0.048*** 0.020 0.635*** 0.008 0.006* 0.110*** 0.001 0.011*** 0.004*** 0.003 0.036

0.043*** 0.022 0.640*** 0.010 0.020*** 0.018***

0.011*** 0.005*** 0.009** 0.035

0.011*** 0.005*** 0.009** 0.035

The following regression is estimated using 146,129 observations from 43 countries: DVolatility = b0 + b1Imbalance + b2Price + b3Market cap. + b4Change in market volatility + b5Momentum + b6Emerging mkt + b7Short selling feasible + b8Market maker + b9Shareholder right + b10Insider law enforced + e. Model 1 uses absolute institutional decision imbalance which is the unsigned dierence between institutional buy and sell orders. Model 2 is an alternative specication, in which buy and sell imbalances are used as separate explanatory variables. Model 3 in the last column explores interaction between these imbalances and short sale feasibility. Dependent variable is the change in volatility due to institutional trading and is computed as the dierence between average daily volatility during the trading period and a benchmark period 15 days before the decision, i.e., Volatility(d, t) Volatility(d 15, d). ***, **, and * indicate statistical signicance at 1%, 5%, and 10% levels, respectively.

the imbalance on either side, higher will be the volatility spike during the trading period. Also, positive coecient on price suggests that high priced stocks are more volatile than low priced stocks. As expected, higher market volatility is associated with higher return volatility in individual stocks. The coecient on momentum motivated trade indicator is insignicant. Momentum strategies are statistically no dierent from contrarian strategies in terms of their volatility eects. Consistent with past literature, volatility is higher in emerging markets and lower on stocks originating from countries with better shareholder rights. Models 1 and 2 give the initial appearance that short-selling feasibility might increase volatility. However a deeper analysis with interactive variables in Model 3 indicates that feasibility of short selling in foreign markets actually lowers volatility on stocks in which institutions carry buy imbalances. This is consistent with our hypothesis that hot money is less able to destabilize a market with bullish momentum trading if arbitragers are able to counter them with short sales. Moreover, the coecient on the interaction of sell imbalances with short sell feasibility is statistically insignicant which mitigates the concerns about ill eects of short selling in bearish markets. The negative coecient on market makers in all models suggests that the presence of designated market makers helps to reduce volatility during the trading period because of their armative obligation to provide liquidity and to ensure smooth price movements from trade to trade.

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Interestingly, enforcement of insider trading laws does not reduce volatility and the coecient is actually positive. This result is consistent with Cao et al. (2004) who nd that insider trading after IPO lock-up expirations actually improves liquidity, suggesting that expected losses to insiders are minor compared to other costs of trading. Moreover, news events will create more volatility shocks if there is no prior leakage of information through the activities of insiders, consistent with Bhattacharya et al. (2000) who show that in a country with no enforcement of insider trading laws, prices do not react to news announcements because prices had already been moved by insider-trading before the announcement. This implies that in countries where insider-trading laws are strictly enforced, the increase in volatility due to institutional trading should be larger. 4. Robustness checks To ensure that our results are not unduly aected by how we dene momentum and contrarian trades, we also use past 2-day, 5-day, and 15-day pre-decision returns to dene trades. Our results are robust to momentum/contrarian trades dened using various past return intervals. We also dene trades using raw returns instead of market adjusted returns. Once again, our basic message is unaltered. As a robustness check, we examine other measures of volatility such as ABSRET in Lee et al. (1994). This measure is based on absolute returns over a given time interval, and in our case daily absolute returns are used. The picture with ABSRET is very similar to that seen in Fig. 2 earlier; absolute returns spike during the trading period compared to the predecisions benchmarks. However, after the completion of trades absolute returns are same as, if not lower than, benchmarks. Our study considers volatility from the point of view of a US investor since all our results are based on dollar based returns. This approach reects relative changes in volatility of exchange rates, as well as equity values, across world markets. To ascertain the eect of exchange rate volatility on the relative dynamics of volatility in these markets, we have reproduced all the results in local currencies (results available upon request). Removing the eect of exchange rate volatility does not change our overall ndings about the dynamics of volatility around institutional trades. 5. Conclusions We examine whether institutional trading decisions induce a higher volatility. We analyze daily volatility for several intervals around decisions, and nd higher volatility only during a brief period when institutions are making trades. This hardly qualies as a destabilizing eect. Instead the pattern is a reection of high institutional trading costs in foreign markets. Cross sectional regressions suggest that the degree of institutional trading imbalances, higher prices, strictness in the enforcement of insider trading laws, and emerging markets classication are positively associated with temporary increases in volatility whereas the presence of market makers and better shareholders rights dampen such increases. Feasibility of short selling in foreign markets lowers temporary volatility on stocks in which institutions carry buy imbalances. Our analysis of post-transaction volatility yields surprising results. We nd absolutely no evidence of higher volatility after the institutions trades are completed. Even the momentum motivated decisions of institutions do not have a long lasting eect on stock

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price volatility. In most of the cases, the magnitude of institutional imbalance also does not have a signicant impact on volatility change between post-transaction and pre-decision periods. Furthermore, although volatility in emerging markets is generally much higher, it also quickly reverts back to the pre-decision level. In sum, all of our sub-samples, the levels of post-transaction volatility are the same or slightly lower than their pre-trade benchmarks. Thus, the characterization of foreign institutions as speculators having a destabilizing eect on markets is unwarranted. Post trade volatility should not be a concern in promoting ever increasing globalization of institutional investment activity. Acknowledgments We are grateful to Wayne Wagner and Vinod Pakianathan of the Plexus Group for providing us with the data and for related discussions. We would like to thank Richard Michelfelder and two anonymous referees for useful comments. Financial support from Morgan Keegan & Company, Inc., is acknowledged. Kelli Kirk provided excellent research assistance. Any errors are our own. References
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