Before the tax-law changes of 1986, common stock repurchases received favorable tax treatment relative to cash dividends, yet more than 80% of the New York Stock Exchange-listed firms did not use repurchases for distributing value to their stockholders. Prior research suggests a possible resolution of the puzzle by examining the effect of open market repurchases on the liquidity of the firms' stocks. The liquidity of the stock as measured by bid-ask spread may be affected by stock repurchases in any one or all of the following ways. First, when management undertakes to reacquire the firm's shares in the open market they are, in effect, competing with the market makers of the stock. This open market repurchase activity, in the absence of information asymmetry, should result in greater liquidity or lower bid-ask spread. Second, a direct consequence of open market repurchase announcements may be increased trading in the secondary market. Increased trading volume makes it easier for the market maker to reverse his position in the stock. Therefore, the inventory holding cost component of bid-ask spread should decline upon announcements of open market repurchases. A decline in the bid-ask spread would be consistent with this explanation. Third, prior research suggests that open market repurchase announcements are associated with increased trading by informed traders in the secondary market for the firm's stock. Informed traders trade with market makers only at favorable prices. Hence, the adverse selection component of the bid-ask spread should increase in the post-announcement period. This information-asymmetry- based explanation predicts increased bid-ask spreads following announcements of open market repurchases. However, it should be noted that an asymmetric-information-based explanation does not necessarily imply that other market participants face the informed traders in all trades at all times. Specifically, the likelihood of trading with an informed trader is greater when stock prices are lower rather than higher. Also, repurchases only involve buying and not selling by informed traders. Hence, the risk of trading against the informed trader is much less. An earlier study reports that bid-ask spread increases when firms announce their intention to reacquire common stock. It is argued that the increased bid-ask spread leads to an increased cost of capital. This hidden cost associated with open market repurchases may explain the preference for cash dividends. However, due to data constraints, the earlier study uses annual bid-ask spreads to document the changes in liquidity. The use of annual data imposes certain limitations. Using annual data, it is not possible to examine when the percentage spread increases with respect to the announcement date, that is, before or after the event. For instance, if the percentage spread is measured at year-ends and the event occurs in between, then an increase in post-event percentage spread may suggest that the event induces the change in the spread. However, the spread could have increased prior to the event and remained stable thereafter. The availability of daily bid-ask spread data for our sample of National Market System (NMS)-listed stocks facilitates a close examination of liquidity changes surrounding the announcement of open market repurchase programs. We find a significant increase in the percentage spread in the 60-day period immediately preceding the event. Further, this increase in percentage spread is more pronounced in the 30-day period immediately prior to the announcement day. In subsequent periods, we find no further change in percentage spreads. Our results indicate that percentage spreads increase prior to open-market repurchase announcements. These findings are not consistent with the proposition that open-market repurchase program announcements cause an increase in percentage spreads. We test die robustness of our result by using a control sample of firms that are matched with our sample firms by market value of equity. Cross-sectional regressions indicate that change in common stock price is the most important determinant of the change in percentage bid-ask spread. The change in spread does not differ between the firms announcing the repurchase program and the control sample. The matched-sample results support our univariate test results that the change in prices explains the change in percentage bid-ask spreads. Recent studies suggest that firms buy back shares when their common stock is substantially undervalued. We also find that open-market repurchase programs are initiated following a period of steep decline in stock prices. The announcements are associated with significantly positive average stock price reactions. It appears that managers initiate repurchase programs to shore up declining investor confidence. This may be a partial explanation of why open market repurchase programs are observed less frequently than cash dividends.
