CORPORATE GOVERNANCE AND INFORMATION CONTENT OF STOCK TRADES: EVIDENCE FROM S&P 100 COMPANIES

ABSTRACTThis paper studies the relationship between firms' corporate governance quality and information content of stock trades. Following Hasbrouck (1991) method, a trade's information content is defined as persistent impact of trade innovation on stock price. Using firm-level governance data, we show that the information content is negatively correlated with firms' corporate governance quality for the S&P 100 companies. Further analysis shows that board of directors is the main governance mechanism contributing to the negative correlation, while audit, anti-takeover, and compensation do not play a significant role. Our results provide empirical evidence to support the theory that corporate governance improves firms' information environment. It provides guidance on governance system design to reduce information asymmetry.JEL: G30, G34KEYWORDS: Information Content, Corporate Governance, Governance Mechanisms, Vector Autoregression (VAR)(ProQuest: ... denotes formulae omitted.)INTRODUCTIONCorporate governance is a set of mechanisms designed to minimize agency problems between investors and managers (Jensen, 1993, Shleifer and Vishny, 1997, Core et al., 2003, Armstrong et al., 2010, among others). Information asymmetry is suggested to be the main source of agency problems, and the relationship between corporate governance and information asymmetry has been studied extensively in corporate finance. Strong corporate governance at firm level can limit information asymmetry. Theoretically, higher corporate governance quality leads to lower information asymmetry. In other words, corporate governance should be negatively correlated with information asymmetry. Existing empirical studies provide conflicting evidence. Some studies (Bushman et al., 2004, Bebchuk, 2002, Cai et al., 2007, Demsetz and Lehn, 1985, Ferreira and Laux, 2007, Gillan, Harzell and Startks, 2003, Raheja, 2005, among others) suggest a negative correlation between information asymmetry and corporate governance, while others (Warfield et al., 1995, Ajinkya et al., 2005) provide contradictory results. This relationship is not entirely understood (Armstrong et al., 2010, Dechow et al., 2010). This study adds to our understanding of this important subject by examining the relationship between information asymmetry, which is captured by the persistent impact of trades, and firm-level corporate governance.In a market with asymmetric information, trades convey information that are not anticipated by the market and cause persistent impact on security prices. The higher the information asymmetry is, the higher impact a trade would cause. Hasbrouck (1991, 1995) suggests that trades and price revision can be considered from an econometric perspective as a vector autoregression (VAR) system. Within this VAR framework, the information impact of a trade is defined as the ultimate impact on stock price due to the unexpected component of a trade. It is important to notice that only the persistent impact is defined as the information content because immediate impact is contaminated by transient liquidity effects (such as inventory and order processing cost). These transient liquidity effects would be corrected by the market in the long run, although often very quickly. Therefore, information content may be meaningfully measured as the persistent impact of the trade innovation on price. A larger information content of stock trades indicates a higher information asymmetry.To examine the relationship between information content and corporate governance, we conduct our analysis using detailed firm-level corporate governance data from RiskMetrics database, which provides a comprehensive spectrum of 44 governance attributes. These 44 attributes cover four major governance mechanisms: board of directors, audit, anti-takeover, and compensation & ownership. Using this data set, we construct five governance indexes: a comprehensive governance index Gov44 that integrates all 44 attributes and four governance subindexes that captures a firm's take-over vulnerability, audit quality, board quality, and compensation & ownership incentives. …