Abstract
This paper examines the role of institutional trading during the option backdating scandal of 2006–2007. Unlike their inability to anticipate other corporate events, institutional investors as a group display negative abnormal trading imbalances (i.e., buy minus sell volumes) in anticipation of firm-specific backdating exposures. Consistent with informed trading, the underlying trades earn positive abnormal short- and long-term profits. Moreover, the negative abnormal imbalances are larger in magnitude when backdating is likely a more severe issue. Local institutions, in particular, display negative trading imbalances earlier in event-time and earn consistently higher trading profits than non-local institutions. Although we find some evidence of over-reaction following the arrival of information about the backdating scandal, these patterns are short-lived and exclusively due to the activity of non-local institutions. Overall, institutional investors behave as informed investors, particularly in local stocks, during this prolonged period of heightened uncertainty about corporate reporting and governance practices.
•Institutional investors as a group sell stocks before public exposures of backdating.•These trading imbalances are larger when backdating is a more severe issue.•Consistent with informed trading, the underlying trades earn positive abnormal profit.•Local institutions sell earlier and earn higher trading profits than non-local ones.•There is some over-reaction, exclusively in the activity of non-local institutions.
