Kim 1997

Market Structure, Informed Trading, and Analysts' Recommendations
Author(s): Sok Tae Kim, Ji-Chai Lin and Myron B. Slovin

Source: The Journal of Financial and Quantitative Analysis, Vol. 32, No. 4 (Dec., 1997), pp.
507-524
Published by: Cambridge University Press on behalf of the University of Washington
School of Business Administration
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JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS VOL. 32, NO. 4, DECEMBER 1997
Market Structure, Informed Trading, and Analysts'

Recommendations
Sok Tae Kim, Ji-Chai Lin, and Myron B. Slovin*
Abstract
We examine stock price behavior in response to initial coverage, buy recommendations that
are pre-released to important clients before the stock market opens, and find a strong positive
valuation effect at the open. On average, it takes five minutes of trading for NYSE/AMEX
stocks and 15 minutes for NASDAQ stocks to reflect the private information contained in
these analyst recommendations, so when informational asymmetry is high, the centralized
call market is more efficient than a competitive, but fragmented dealer market. Public news
release leaves share prices unaltered. Overall, competition among informed traders causes
private information to be rapidly incorporated into stock prices.
I. Introduction
Most equity trading in the U.S. occurs in two different market structures.
The NYSE and AMEX are centralized exchanges, while the NASDAQ/OTC mar?
ket is a dealer market. Several researchers, including Kyle (1985), Holden and
Subrahmanyam (1992), and Madhavan (1992), examine how markets incorporate
information into prices, and how different market structures affect the efficiency
of the price discovery process when some traders have private information. How?
ever, it is difficult to test these models because it is difficult to ascertain empirically
when and whether private information is used in trading. In this paper, we find
that a two-tiered process of disseminating analyst recommendations provides a
valuable setting to empirically assess the dynamic efficiency with which prices
reflect informed trading under alternative market structures.
Information about an analyst's stock recommendation typically is given first
to important clients ofthe brokerage firm and subsequently released to the general
public. During the period between the pre-release of information and the public
announcement, these clients possess private information and, thus, can be viewed
as informed traders. The specific form of analyst recommendation examined in this
study is an announcement that a brokerage house is initiating regular coverage with
a buy recommendation for the common stock of a publicly traded firm. Several
* Kim, Dongsuh Securities Co., LTD, Seoul 150-010, Korea; Lin and Slovin, Department of Finance,
Louisiana State University, Baton Rouge, LA 70803, respectively. The authors thank Hans Stoll
(associate editor and referee) for helpful comments.
507
508 Journal of Financial and Quantitative Analysis
recent studies, including Womack (1996), Liu, Smith, and Syed (1990), and Barber
and Loeffler (1993), demonstrate that an analyst's recommendation to buy (sell) a
firm's common stock generates a positive (negative) share price response.
For each observation in our sample, the Dow Jones News Wire (DJNW)
reports the time the news is released to the public and indicates that the recom?
mendation was disseminated to important clients of the brokerage firm before
the market opening. As a result, there are typically several hours during which
informed clients are able to act on the analyst recommendation before the news
is publicly released. To the extent that private information contained in analyst
recommendations has value, informed traders will be able to earn a return on this
information until the price of a common share fully incorporates the new informa?
tion to within transactions costs. The two-tiered process affords an opportunity to
examine how alternative trading mechanisms affect the formation of prices in the
presence of informed trading. Our focus is on the degree to which the opening
transaction on each type of market incorporates this private information, given
that on NYSE/AMEX, the opening trade is conducted in a centralized call market,
while on NASDAQ, the opening trade is conducted in a fragmented dealer market.
Thus, our work assesses how the degree of efficiency varies between the call and
the dealer market mechanisms and how initial coverage recommendations affect
firm value.
Several conclusions emerge from our analysis. First, initial coverage, buy
recommendations have a positive effect on firm value, with an average excess return
of approximately 4% for NYSE/AMEX stocks and 7% for NASDAQ stocks, results
consistent with Womack's (1996) evidence for ordinary buy recommendations.
This implies that brokerage house security analysts enhance firm value by gathering
and disseminating information about undervalued stocks.
Second, based on the pattern of adjusted returns subsequent to the opening
trade, the call market is more efficient than the dealer market in incorporating
private information into share prices since the total price response occurs more
quickly. Specifically, for NYSE/AMEX stocks, almost all of the private informa?
tion contained in analyst recommendations is reflected in the opening trade. There
are only minor gains to informed traders subsequent to the initial trade, gains
that are typically less than transactions costs. In comparison, there are significant
and economically important gains of approximately 3% during the period after
the opening transaction for NASDAQ stocks, implying clients earn excess returns
from the pre-release of analyst recommendations. This evidence is consistent with
Madhavan's (1992) prediction that when informational asymmetry is high, the call
market is more efficient than the dealer market. However, in the call market, con-
siderable time elapses, on average 10 minutes, before the specialist sets a market
clearing price. Thus, in the specialist market, there is a substantial period during
which no market clearing price is found, so there is a loss in liquidity. In com?
parison, the dealer market is ready for trades when the market opens and offers a
trader the opportunity to execute a trade during the period of price discovery.
Third, almost all of the private information is impounded in stock prices
within 15 minutes ofthe opening trade for each market. This speed of response is
consistent with Holden and Subrahmanyam's (1992) prediction that competition
between informed traders causes private information to be rapidly incorporated
Kim, Lin, and Slovin 509
into stock prices. The public release of the recommendation on the news wire has
no effect on share prices, which indicates that activity of informed traders induces
share prices to reflect the full value of the information contained in an analyst
recommendation.
The remainder ofthe paper is organized as follows. In Section II, we discuss
issues of efficiency and their relation to alternative market structures. We consider
whether initial coverage, buy recommendations by analysts affect firm value and
find that the two-tiered process by which these recommendations are released pro?
vides a framework within which to test issues of market efficiency with respect
to private information. Section III describes the sample and presents descriptive
statistics. In Section IV, we report results for the market reaction to analyst rec?
ommendations for the two alternative market structures. We also report results for
a control sample of firms randomly selected from firms in the same capitalization
size decile as corresponding firms in the test sample. Section V concludes the
paper.
II. Analyst Recommendations, Informed Trading, and

Market Microstructure
Issues ofthe relative efficiency of alternative market systems typically revolve

around how the two types of market structures commonly used to trade stocks
reflect the effects of private information and informed trading. Alternative trading
systems that are semi-strong efficient, i.e., reflect all publicly available information,
may display differences in the speed with which prices move to full information
levels. Given that initial coverage recommendations are generally disseminated to
a brokerage firm's important clients prior to the public news release and before the
market opens for trading, we focus on the degree to which the opening transaction
on each type of market is efficient in incorporating the information conveyed by
the recommendation.
The NYSE and AMEX operate as exchange mechanisms that incorporate
floor brokers and a specialist, who has an exclusive right to make a market for the
stock. A continuous auction is generally used in which trades occur individually
and the specialist quotes bid and ask prices. However, the opening transaction
on each exchange is typically conducted in a call market. Prior to the opening
call, limit orders and market-on-open orders accumulate so the specialist knows
the extent of the market order imbalance and limit orders at every price and can
use this information to set the price. The specialist then opens the stock by setting
a single market-clearing price at which all market orders are executed. At this
price, the specialist may either rely on limit orders to offset an imbalance in order
flow or take an offsetting position for his account. In addition, the specialist has
a duty to strive for price stability and continuity, that is, to avoid large jumps
from the previous day's closing price, a goal that could potentially inhibit the
market's adjustment to information, given the two-tiered process by which analyst
recommendations are disseminated.1 Following the open, trading typically reverts

to a continuous auction.
The NASDAQ operates as a competitive computerized dealer market in which
there are a number of dealers with equal access to the market who compete by
simultaneously quoting bid and ask prices. The system is quote driven, that is,
dealers post prices that are the outgrowth of an optimal pricing strategy by each
dealer, designed to maximize utility given that dealer compensation arises from
the bid and ask prices. Thus, it is possible for an investor to conduct several
transactions with different dealers. As a result, the opening trade on NASDAQ is
conducted in a fragmented dealer market, where competing market makers quote
bid prices for sell orders and ask prices for buy orders.
There is continuing controversy about the relative merits of these alternative
trading structures. Much of the market microstructure literature focuses on the
implications of trading by informed investors who have an incentive to maximize
gains from access to private information. The presence of informed traders imposes
costs on uninformed traders whose orders are pooled with the orders of informed
traders. The pooling of informed traders and uninformed (liquidity) traders leads
to a bid-ask spread that increases with the risk and the value of private information.
Whatever its source, private information affords an opportunity for an informed
trader to gain at the expense of other traders. From this perspective, the call
(specialist) market structure typically utilized for the opening trade can be viewed
as an institutional mechanism to enforce sharing of information among brokers
and to serve as a clearinghouse that reduces the ability of agents to exploit private
information relative to a dealer market.
Glosten (1989), Gammill (1992), Madhavan (1992), and Leach and Madha?
van (1993) suggest that the specialist system is a superior form of market organiza?
tion with respect to efficiency. In particular, the ability of a monopolistic specialist
to accept losses on individual trades spurs competition among informed traders
and allows the market to function when it would not be able to remain open under
competitive conditions. Benveniste, Marcus, and Wilhelm (1992) argue that in the
monopolistic setting of the NYSE or AMEX, a specialist has the power to sanc-
tion brokers exploiting private information, which induces the revelation of the
information. From this perspective, the benefits of a specialist system are greatest
when the potential for privately informed trading is greatest. Madhavan (1992)
posits that when there is high informational asymmetry, the call market is more
efficient in reflecting private information than the dealer market. We test which
form of market organization is more efficient in reflecting private information by
comparing share price responses around the release of analyst recommendations
in the call market of NYSE/AMEX and in the dealer market of NASDAQ.
Our analysis demonstrates that private information is quickly incorporated
into market prices. This is an important element for assessing the effect of ana?
lyst recommendations because informed traders who are important clients of the
brokerage firm understand that the relevant information is likely to be made pub?
lic within the trading day. As a result, informed trading is likely to take place
within a concentrated interval. Kyle (1985) posits that in a market with a risk-
*For an analysis of specialist behavior see, for example, Amihud and Mendelson (1987) and Stoll
and Whaley (1990).
neutral monopolistic insider who can strategically exploit private information and
attempts to maximize profits, private information will be gradually incorporated
into security prices. In contrast, Holden and Subrahmanyam (1992), who extend
Kyle's model by allowing the number of informed traders to vary assuming that
all informed traders have the same information, demonstrate that as the number
of traders increases, their strategy causes them to trade so private information is
instantly or rapidly impounded in security prices. As a result, there is not enough
noise trading to preserve the return to information that occurs when noise traders
dominate the order flow. From this perspective, prices become fully revealing at
the onset of trading. Since brokerage house clients who have access to the pre-
release of analyst recommendations recognize that this access is only for a limited
period of time and is necessarily shared with other important clients, there is likely
to be extensive competition for profits. Our data provide a test of Holden and
Subrahmanyam's hypothesis.
Our analysis also generates evidence about the value of announcements of
initial coverage of a firm by a brokerage house. Analysts devote considerable
effort and resources to assessing the firms they cover, including the preparation of
earnings forecasts. If an initial coverage, buy recommendation is a positive signal
of firm value, corporate managers with positive private information are likely to
conduct activities designed to attract the attention and interest of analysts. A firm
with favorable information will be willing to absorb the costs of attempting to
induce analysts to cover the firm since the information that analysts provide to
investors is likely to be favorable. From this perspective, our work provides an
opportunity to determine if the decision of a brokerage house to initiate coverage
of a stock with a buy recommendation enhances the market value of the firm and
to assess the dynamics of how prices respond to the two-tiered process by which
this information is released.
III. Sample Data

Our sample consists of announcements of an analyst's initial coverage of a
firm with a buy recommendation, reported on the Dow Jones News Wire in 1991.
Announcements of initial coverage of a firm with a recommendation other than
a buy are uncommon during this period and insufficient to generate an effective
sample for testing. The following selection criteria are used to develop the sample.
We search for news about analyst recommendations issued during 1991 through
the Dow Jones News Retrieval system using the key words "analyst$ and initia$
and cov$." This procedure results in 115 observations of initial coverage of a
firm by an analyst with a buy recommendation. Each report contains the date and
time that the recommendation is released to the Broad Tape, the company's ticker
symbol, the identity of the analyst, the name of the brokerage house with which
the analyst is affiliated, and the content of the recommendation.
To examine the effects of the behavior of informed traders, it is critical to
know both the time a recommendation becomes privately accessible to the broker?
age firm's important clients and the time the information is released to the public.
Ofthe 115 recommendations, there are 87 cases that meet two criteria essential for
our empirical analysis: i) news released on the DJNW indicates that the recom-
mendation was disseminated to the brokerage firm's clients prior to the opening
of the market; and ii) the firm is included on the 1991 ISSM tapes. Of the 28
events omitted from the sample, there were 25 cases in which there was no clear
indication ofthe time when the recommendation was pre-released to the brokerage
firm's clients and three cases of (non-NMS) firms for which transaction data are
not included on the ISSM tapes. Thirty-four brokerage houses account for the
initial coverage recommendations in the sample. The four brokerage houses with
the most observations in the sample are Morgan Stanley (10), Shearson Lehman
(10), Smith Barney (9), and Bear Stearns (8). There are 42 events for firms listed
on NYSE/AMEX and 45 events for firms traded on NASDAQ/NMS.
Relevant descriptive statistics for the characteristics of sample firms are re?
ported in Table 1, Panel A for NYSE/AMEX and Panel B for NASDAQ, and
include average daily trading volume, average daily trading frequency, average
trade price, average dollar bid-ask spread, and average relative bid-ask spread.
For each variable, the mean and median are reported for three different periods: a
pre-event period that covers days ?50 to ?3, the event period, day 0, which is the
recommendation release day, and a post-event period that covers days 3 to 10.
Mean daily trading volume for NYSE/AMEX sample firms increases signif?
icantly from 172,600 shares in the pre-event period to 344,800 shares on the day
analyst recommendations are released, and then decreases to 187,200 shares in
the post-event period. For NASDAQ firms, mean daily trading volume increases
significantly from 166,700 shares in the pre-event period to 418,700 shares on the
day analyst recommendations are released, and then decreases to 152,800 shares
in the post-event period. Thus, both NYSE/AMEX and NASDAQ firms in the
sample are actively traded and sustain large one-day increases in trading volume
during the event day. The data for trading frequency display a comparable pattern
with a significant increase observed for the event day, followed by a decrease in the
post-event period. For NYSE/AMEX firms, the mean trading frequency increases
significantly from 104 trades per day in the pre-event period to 199 trades per day
in the event period, and then decreases to 125 trades per day in the post-event pe?
riod. For NASDAQ firms, the mean trading frequency increases significantly from
85 trades per day in the pre-event period to 224 trades per day in the event period,
and then decreases to 90 trades per day in the post-event period. This indicates
that the release of initial coverage, buy recommendations generates a significant
increase in trading activity, consistent with evidence reported by Womack (1996).
IV. Market Structure and the Speed of Price Adjustment

A. The Effects of Informed Trading on Transaction Prices
We address several questions related to the process by which the effects of

informed trading are impounded in common stock prices. First, does an initial
coverage, buy recommendation influence firm value? Second, if such analyst rec?
ommendations affect value, how rapidly do stock prices incorporate the private
information contained in these recommendations, given that the speed of adjust?
ment of prices depends on the extent of informed trading? Third, which of the
two market structures, the call market or the dealer market, is more efficient in
TABLE 1
Characteristics of the 87 Sample Firms that Received Analysts' Initial Coverage Buy
Recommendations in 1991 (Day 0 is the Recommendation Release Day)
aQuoted dollar spread = ask-bid.

bEffective dollar spread = 2|P- Q\, where Pis the transaction price and Q = (ask + bid)/2.
cEffective relative spread = 2| log(P) - log(Q)|.
The signs ++ and + ("" and ") indicate that the mean or median in this period is significantly
larger (smaller) than in the preceding period at the 1% and 5% levels, respectively. The
significance for the mean difference is based on the paired Mest and for the median is
based on the signed rank test.
the sense of reaching the full information level of prices faster? We obtain the
average return measured at the opening trade (i.e., the overnight return) and a se?
ries of five-minute returns for the day of the release of analyst recommendations.
The opening trade is a critical factor because these analyst recommendations are
disseminated to the brokerage firm's important clients before the market opens at
9:30 a.m. Hence, the opening trade is the first transaction that is likely to reflect
this private information.
We use the mean-adjusted method to compute abnormal returns. Wood,
Mclnish, and Ord (1985) and Harris (1986) show that opening trade returns and
last trade returns tend to behave differently from the returns for trades that occur
between the opening and closing trades. For this reason, we take account of the
pattern of intraday returns when computing mean-adjusted returns. Based on the

intraday pattern of returns, we compute three mean returns for each firm using
the estimation period, days -50 to -3. These are the mean (overnight) return at
the first trade, the mean return in the last five minutes, and the mean five-minute
returns for the period between the opening and the closing trades. If a firm has no
trade in a given five-minute interval, the return in that interval is set equal to zero.
The abnormal return, or mean-adjusted return, for firm i at time t is then measured
as
AR|Y = Rit ~MRis,
where s = 1 if tis the opening trade, s = 2 if tis in the last five minutes, and s = 3
if t is in between the opening trade and the last five minutes of trading.
In Table 2, we report average abnormal returns around the opening trade on
the day ofthe release of analyst recommendations for the samples of NYSE/AMEX
firms and NASDAQ firms. These returns are graphed in Figure 1. For each sample
of firms, the event time for the opening trade is denoted as zero. The event times
1,2,3,..., indicate the first, second, third, and subsequent five-minute intervals
after the opening trade. Likewise, the event times -1, -2, -3,..., indicate the
last, the second to the last, the third to the last, and earlier five-minute trading
intervals on the day before the news release day. The average abnormal return
in a given interval is obtained by averaging across the sample firms. We use a
Mest (with the standard error computed across sample firms in that interval) and
a signed rank test to indicate the significance of the average abnormal return in a
given interval.
For the sample of NYSE/AMEX firms, the average abnormal return at t = 0,
that is, the opening trade, is 3.78%, which is statistically significant at the 1%
level, given a f-statistic of 6.30. For 93% of sample firms, there is a positive return
at the opening trade. The average abnormal return at t = 1, that is, five minutes
after the opening, is 0.57%, which is also significant at the 1% level, given a t-
statistic of 2.93, and 57% ofthe firms have a positive return. The average abnormal
returns in the subsequent five-minute intervals are small and not significant. The
results indicate that initial coverage, buy recommendations have a large positive
impact on firm value and are similar to Womack's (1996) findings ofa 3.0% return
over a three-day interval for ordinary buy recommendations. Our results indicate
that most of the information contained in analyst recommendations is reflected in
stock prices at the opening trade and trades that occur within the succeeding five
minutes, well before public release of the recommendation. Our findings imply
that the call market used at the opening transaction on NYSE/AMEX reveals most
of the information contained in analyst recommendations even though no public
news release occurs for several hours.
The returns prior to the opening trade are small and not significant so there is
no evidence of informed trading prior to the open. This indicates that investment
banks are able to keep information concerning forthcoming analyst recommenda?
tions from traders prior to the time the news is released to important customers.
This suggests the effectiveness of internal information barriers, or "Chinese Walls"
that securities firms have established to prohibit internal information transfer that
could potentially conflict with the interests of customers.
TABLE 2
Five-Minute-lnterval Abnormal Returns around the First Trade on the Release Day of
Analysts' Initial Buy Recommendations Appearing on the Broad Tape
(the return at event time 0 is based on the first trade return (overnight return) on the news
release day and the rest are based on five-minute interval returns)
For the NASDAQ sample, the average abnormal return at t = 0, the opening
xade, is 3.63%, which is statistically significant at the 1% level, given a f-statistic
)f 4.68, and close to the figure obtained for NYSE/AMEX firms. For 78% of
he NASDAQ firms, there is a positive return at the opening trade. The average
ibnormal returns in the two subsequent five-minute intervals are 1.61% and 1.19%,
jach significant at the 1% level and with 69% of the returns positive. There is a
eturn of 0.49% for the third five-minute interval, which is not significant given
i f-statistic of 1.54 (the proportion of returns positive is 50%). The abnormal
eturns in the remaining five-minute intervals are small and not significant and
lone of the returns prior to the open is significant. The results indicate that most
)f the information contained in analyst recommendations is incorporated into stock
>rices within 15 minutes after the opening trade. The overall magnitude of these
eturns, 7.0%, indicates that initial coverage, buy recommendations by analysts
lave a stronger valuation effect for NASDAQ firms than for NYSE/AMEX firms.
Jince NASDAQ firms generally have smaller market values than NYSE/AMEX
FIGURE 1
Abnormal Returns in Five-Minute Intervals around the Opening Trade (Event Time 0) on the
Release Day of Analysts' Initial Buy Recommendations
3.5 +
3
b NYSE&AMEX Firms
2.5- ? NASDAQ Firms
e 2
fc 1.5
0.5
0 'l-lll8-l^lgWl- ?|J|?-I ?|M|I|I|*I M|*L| l|L|J|J| l(
-0.5
offlopstDifi'tcowr-O'-wn^mtDNooffio
Event Time
firms, this result is consistent with Atiase's (1985) contention that information
production for the purpose of identifying mispriced securities is related to firm
size, so the expected change in corporate valuation induced by announcements
such as analyst recommendations should be inversely related to the market value
of the firm. Our finding is also consistent with evidence that the financial market's
reaction to earnings announcements is related to firm size, as reported by Atiase
(1985), Collins, Kothari, and Rayburn (1987), and Freeman (1987).
The evidence reported in Table 2 has several implications for the effect of
market microstructure on the impact of analyst recommendations. The results
indicate that both the specialist-oriented exchanges, NYSE and AMEX, and the
dealer-based NASDAQ market react quickly to informed trading. This evidence is
consistent with Holden and Subrahmanyam's (1992) hypothesis that competition
among informed traders causes private information to be rapidly impounded into
stock prices. These speeds of price adjustment to private information are compara?
ble to the speeds of price adjustment reported for public earnings announcements
(Patell and Wolfson (1984)) and public announcements of equity issuance (Barclay
and Litzenberger (1988)). Nevertheless, in terms of dynamic efficiency, the results
suggest that there are differences between the call market and the dealer market.
For the NYSE/AMEX sample firms, there are very small abnormal returns after
the opening, suggesting that the price established in the call market at the opening
trade reflects almost all ofthe eventual effect ofthe private information. The small
return observed in the five minutes subsequent to the opening implies there are few
gains available to important brokerage firm clients, that is informed traders, from
the pre-release of analyst recommendations for NYSE/AMEX stocks. The pattern
of these results also provides support for the Benveniste, Marcus, and Wilhelm
(1992) contention that specialists enforce an informal agreement among brokers
to share information.
For NASDAQ firms, the abnormal returns for intervals subsequent to the
opening trade are large and statistically different at the 5% level from the com?
parable returns for NYSE/AMEX firms. The fact that there are large average
abnormal returns for succeeding intervals and that a preponderance of the firms
have positive returns in these intervals implies that a substantial proportion of the
private information is not reflected in prices established at the opening trade in a
dealer-based market. The slower price adjustment on the NASDAQ dealer-based
market may be due to the fact that fragmentation and multiple market makers al?
low informed traders to more effectively conceal their trading. As a result, the
NASDAQ market is characterized by slower discovery of informed trading.
The substantial return observed in the 15 minutes subsequent to the opening,
approximately 3%, implies that there are significant gains available to a brokerage
firm's important clients, that is informed traders, from the pre-release of analyst
recommendations for NASDAQ stocks, assuming that these investors can trade
with modest transactions costs. Thus, the response of the dealer-based system
implies that private information presents a strategic opportunity for a broker to
obtain better execution of a principal's order at the expense of other traders. These
gains also imply that major investors should be willing to establish a relationship
with a brokerage firm and to pay for private access to this investment advice through
commissions or other fees. The non-trivial magnitude of these returns implies that
pre-release of analyst recommendations provides a channel by which brokerage
firms can be compensated for information search costs they incur in generating
this information. This result is consistent with Grossman and Stiglitz's (1980)
view of market efficiency, i.e., that there must be returns available to compensate
agents for the information search costs they incur. In comparison, the specialist
is apparently able to induce informed traders to reveal their private information,
which allows for the pooling of informed and uninformed traders at the opening
transaction.
Although we use the opening trade as the starting point on both markets,
the exact time of the opening trade on day 0, the release day for analyst recom?
mendations, on NYSE/AMEX is generally different from that on NASDAQ. As
reported in Table 3, the opening trade for firms in the NYSE/AMEX sample oc?
curs, on average, 10.69 minutes (median of 7.00 minutes) after the market opens
at 9:30 a.m. This indicates that it takes approximately 10 minutes for the specialist
to clear the market at the opening trade. For NYSE/AMEX sample firms, this time
interval ranges from zero minutes to a maximum of 55 minutes. In comparison,
the opening trade for the NASDAQ sample firms occurs, on average, 0.81 minutes
(median of 0.00 minutes) after the market opens at 9:30 a.m., with a range from
zero to four minutes. The difference between the time intervals for the two types
of markets is statistically significant at the 1% level. Moreover, there is a sharp
difference in the volume of trading at the first trade for NYSE/AMEX firms vs.
NASDAQ firms, as indicated in Figure 2, which reports average trading volume
around the opening trade on the release day relative to average trading volume
during the pre-event period.2 In particular, there is a large increase in volume for
the opening transaction on NYSE/AMEX (a centralized call market) but not on
NASDAQ (a competitive dealer market).
TABLE 3
Time Intervals from the Market Open at 9:30 a.m. to the Time of the First Trade in the
Pre-Event Period, the Event Period, and the Post-Event Period
The signs ++ and + ("' and") indicate that the mean or median in this period is significantly
larger (smaller) than in the preceding period at the 1% and 5% levels, respectively. The
significance for the mean difference is based on the paired Mest and for the median is
based on the signed rank test.
The implication of our results is that the call market used by NYSE/AMEX
at the opening trade is highly efficient in revealing private information, but it takes
a significant amount of time for the specialist to clear the market. Thus, for a
specialist system, there is a considerable period of time during which there is no
market clearing price. By comparison, the dealer-based market system used by
NASDAQ, which is not as efficient as the call market in impounding the private
information associated with the pre-release of analyst recommendations, is ready
for trading when the market opens. Therefore, there is a tradeoff between efficiency
(or the amount of private information revealed from the opening trade in a market)
and liquidity (the time needed to complete the trade).
B. The Quote Midpoint
We further examine the speed of price adjustment to private information by

using returns computed from the quote midpoint, that is, the average of bid and
ask prices, as reported in Table 4. There are two advantages to using quote-
midpoint returns. First, returns based on quote midpoints are less influenced by
bid-ask bounces. Second, quote prices can be adjusted even if there are no trades.
As a result, quote prices tend to contain more recently updated information than
transaction prices, which may be reported with a lag. For the NYSE/AMEX
sample, t is set equal to zero at the first quote revision, which usually occurs
immediately after the opening trade. Hence, the return at t = 0 reflects the overnight
return, and returns at t = 1,2,3,... are the succeeding five-minute returns. The
2 Average trading volume during the pre-event period is computed using a procedure that takes into
account the intraday pattern of trading and that parallels the method used to calculate mean returns
during the pre-event period.
FIGURE 2
Ratios of Trading Volume to Normal Volume, in Five-Minute Intervals around the Opening
Trade (Event Time 0), on the Release Day (Day 0) of Analysts' Initial Buy Recommendations
(the normal volume is estimated from days -50 to -3)
35
* NYSE&AMEX Firms
30 +
? NASDAQ Firms
25
20
15
10
5+
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| wm | ? |_? [ ?? [ w | mm | w | w [ w j ,w | =*f | *M-{-
OOTCD^COm^OOCMT-OT-CMCO^LOCOr^OOCnO
Event time
average abnormal returns at t = 0 and t = 1 are 3.79% and 0.72%, both significant at
the 1% level. Other abnormal returns are small and not significant. This evidence
accords with the results reported earlier and suggests that the specialist and other
market participants are able to incorporate most of the private information of
analyst recommendations within five minutes after the first quote revision.
For the NASDAQ/OTC market, we examine to what extent market makers
adjust quotes before the market opens. In particular, traders can submit orders
before the market opens, so market makers can gain information from traders
before the market opens. For most sample firms, we observe quote revisions
before the market opens at 9:30 a.m. on the news release day. For the NASDAQ
sample, the average abnormal returns are statistically significant at t = 0 (3.20%),
t = 1 (2.19%), t = 2 (0.68%), and t = 3 (0.34%). These results indicate that
market makers adjust quote prices to incorporate private information about analyst
recommendations for about 15 minutes after the market opens. In addition, there
are small, but marginally significant abnormal returns before the market opens.
This implies market makers are able to perceive the existence of some private
information even before the market opens.
C. The Control Sample
For each sample firm, we randomly select a control firm from the same cap?
italization size decile as of the end of 1990. The control sample affords an op?
portunity to examine whether the effects observed are due to informed trading
induced from the release of analyst recommendations and, thus, are unique to the
TABLE 4
Five-Minute-lnterval Quote Mid-Point Abnormal Returns around the First Quote after the
Market Opens at 9:30 a.m. on the Release Day of Analysts' Initial Buy Recommendations
Appearing on the Broad Tape (the return at event time 0 is based on the first quote midpoint
return (overnight return) on the news release day and the rest are based on five-minute
interval returns)
test sample firms.3 We expect that stock prices of the control sample, on average,
should display normal behavior, i.e., no abnormal returns, on the days analyst
recommendations are released. Since there is no specific information related to
control sample firms, we expect their stock prices should behave similarly in the
NYSE/AMEX centralized exchange market and the NASDAQ dealer market.
The control sample results are reported in Table 5. As expected, stock prices
of firms in the control samples show no abnormal returns around the opening trade
on the days the buy recommendations on the test sample firms are released. There
are also no significant differences between the NYSE/AMEX and the NASDAQ
control sample firms. The results for the control samples suggest that our findings
are unique to the test sample firms and are not merely the result of chance.
3 Because it is possible that analyst buy recommendations may have an intra-industry effect, we
did not utilize a control sample of firms that are drawn from the same industry. A randomly selected
control sample would not systematically reflect any intra-industry effect that may exist.
TABLE 5
Control Sample Five-Minute-lnterval Abnormal Returns around the First Trade on the
Release Day of Analysts' Initial Buy Recommendations on the Test Sample Firms
Appearing on the Broad Tape in 1991 (the return at event time 0 is based on the first trade
return (overnight return) on the news release day and the rest are based on five-minute
interval returns. For each sample firm, a control firm is randomly selected from the firms
that are in the same size decile as the sample firm at the end of 1990)
D. Effects at the Public News Release
On average, the private information period, i.e., the time between the market
opening at 9:30 a.m. and the time analyst recommendations are released to the
public, is two hours and 38 minutes for NYSE/AMEX firms, and two hours and
51 minutes for NASDAQ firms. If common stock prices rapidly and effectively
incorporate private information about analyst recommendations, there should be
no significant valuation effect at the time the news is released to the public on the
news wire. Abnormal returns at the time of the public release, reported in Table
6, are consistently small and not significant for NYSE/AMEX or NASDAQ firms.
Thus, both types of market structures are effective in facilitating reliable price
discovery prior to public release of analyst recommendations.
TABLE 6
Five-Minute-lnterval Abnormal Returns around the Time of Analysts' Initial Buy

Recommendations Appearing on the Broad Tape
(the event time 0 refers to the first trade after the news appeared on the Broad Tape)
V. Conclusions
In this paper, we examine issues relating to informed trading and market

efficiency by assessing the impact of analyst initial coverage, buy recommendations
on common stock prices and evaluating differences by type of market, given that the
opening trade is conducted in a centralized call market on the NYSE/AMEX, and
in a fragmented dealer market on the NASDAQ. Harris, Mclnish, Shoesmith, and
Wood (1995) examine transaction data for IBM and find that trading on regional,
specialist-based exchanges plays a significant role in the price discovery process.
Our results indicate that both the call (specialist) market and the dealer market
display considerable dynamic efficiency. On average, relative to the opening trade,
it takes five minutes for NYSE/AMEX stocks and 15 minutes for NASDAQ stocks
to reflect the private information in analyst recommendations. These results are
consistent with Holden and Subrahmanyam's (1992) prediction that competition
between informed traders causes private information to be rapidly incorporated
into stock prices. In both types of markets a preponderance of the ultimate change
in price occurs at the first trade. The actual release of the recommendation on the
news wire leaves share prices unaltered so the activity of informed traders captures
the full value of the information contained in the recommendation. Thus, trading
by informed traders abets the goal of equilibrium price discovery.
Based on the magnitude of abnormal returns that occur subsequent to the
opening trade, the call market is more efficient than the dealer market in incor?
porating private information into share prices since a greater proportion of the
ultimate effect occurs at the first trade in specialist markets. This evidence is con?
sistent with Madhavan's (1992) prediction that when informational asymmetry is
high, the call market is more efficient than the dealer market. However, in the call
market, it takes a significant period of time for the specialist to set a market clearing
price, so traders face a considerable period during which no market clearing price
is found. In comparison, the dealer market is ready for trades when the market
opens and offers the trader greater liquidity during the period of price discovery.
Informed traders who transact at the first trade in the dealer (NASDAQ) market
earn a substantial return, approximately 3%, in the 10-minute period following the
initial trade. This implies that important clients are able to earn excess returns from
brokerage relationships. An informed trader who transacts at the initial trade in a
specialist market earns only an economically small, though statistically significant
return, in the succeeding five minutes.
Overall, an initial coverage report with a buy recommendation by an analyst
has a significant effect on firm value, increasing share prices of NYSE/AMEX
firms by approximately 4% and NASDAQ firms by 7%. This suggests there is
value to the information collection activities of brokerage firms and analysts and
that an element of this value accrues to the benefit of their important clients.
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Market Structure, Informed Trading, and Analysts' Recommendations

Author(s): Sok Tae Kim, Ji-Chai Lin and Myron B. Slovin

University of Washington School of Business Administration, Cambridge University

Market Structure, Informed Trading, and Analysts'

Sok Tae Kim, Ji-Chai Lin, and Myron B. Slovin*

II. Analyst Recommendations, Informed Trading, and

Issues ofthe relative efficiency of alternative market systems typically revolve

recommendations are disseminated.1 Following the open, trading typically reverts

III. Sample Data

IV. Market Structure and the Speed of Price Adjustment

We address several questions related to the process by which the effects of

aQuoted dollar spread = ask-bid.

pattern of intraday returns when computing mean-adjusted returns. Based on the

AR|Y = Rit ~MRis,

2.5- ? NASDAQ Firms

0 'l-lll8-l^lgWl- ?|J|?-I ?|M|I|I|I M|L| l|L|J|J| l(

B. The Quote Midpoint

We further examine the speed of price adjustment to private information by

H ul I mmi J i wB[ Iwm\

C. The Control Sample

D. Effects at the Public News Release

Five-Minute-lnterval Abnormal Returns around the Time of Analysts' Initial Buy

In this paper, we examine issues relating to informed trading and market

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