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The Effects of Insider Trading on Insiders' Choice Among Risky Investment Projects

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  • Lucian Arye Bebchuk
  • Chaim Fershtman

Abstract

This paper studies certain effects of insider trading on the principal-agent problem in corporations. Specifically, we focus on insiders' choice among investment projects. Other things equal, insider trading leads insiders to choose riskier investment projects, because increased volatility of results enables insiders to make greater trading profits if they learn these results in advance of the market. This effect might or might not be beneficial, however, because insiders' risk-aversion pulls them toward a conservative investment policy. We identify and compare insiders' choices of projects with insider trading and those without such trading. We also study the optimal contract design with insider trading and without such trading, thus identifying the effects that allowing such trading has on other elements of insiders' compensation. Using these results, we identify the conditions under which insider trading increases or decreases corporate value by affecting the choice of projects with uncertain returns .

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Technical Working Papers with number 0096.

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Date of creation: Feb 1991
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Publication status: published as Journal of Financial and Quantitative Analysis, vol. 29, no. 1, pp. 1-4 (1994)
Handle: RePEc:nbr:nberte:0096

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  1. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, Elsevier, vol. 14(1), pages 71-100, March.
  2. Lucian Arye Bebchuk & Chaim Fershtman, 1991. "The Effect of Insider Trading on Insiders' Reaction to Opportunities to "Waste" Corporate Value," NBER Technical Working Papers, National Bureau of Economic Research, Inc 0095, National Bureau of Economic Research, Inc.
  3. Dye, Ronald A, 1984. "Inside Trading and Incentives," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 57(3), pages 295-313, July.
  4. Ausubel, Lawrence M, 1990. "Insider Trading in a Rational Expectations Economy," American Economic Review, American Economic Association, American Economic Association, vol. 80(5), pages 1022-41, December.
  5. Finnerty, Joseph E, 1976. "Insiders and Market Efficiency," Journal of Finance, American Finance Association, American Finance Association, vol. 31(4), pages 1141-48, September.
  6. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1315-35, November.
  7. Mirman, Leonard J & Samuelson, Larry, 1989. "Information and Equilibrium with Inside Traders," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 99(395), pages 152-67, Supplemen.
  8. Jaffe, Jeffrey F, 1974. "Special Information and Insider Trading," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 47(3), pages 410-28, July.
  9. Radner, Roy, 1979. "Rational Expectations Equilibrium: Generic Existence and the Information Revealed by Prices," Econometrica, Econometric Society, Econometric Society, vol. 47(3), pages 655-78, May.
  10. Laffont, Jean-Jacques & Maskin, Eric S, 1990. "The Efficient Market Hypothesis and Insider Trading on the Stock Market," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(1), pages 70-93, February.
  11. Seyhun, H. Nejat, 1986. "Insiders' profits, costs of trading, and market efficiency," Journal of Financial Economics, Elsevier, Elsevier, vol. 16(2), pages 189-212, June.
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Cited by:
  1. Lucian Arye Bebchuk & Chaim Fershtman, 1991. "The Effect of Insider Trading on Insiders' Reaction to Opportunities to "Waste" Corporate Value," NBER Technical Working Papers, National Bureau of Economic Research, Inc 0095, National Bureau of Economic Research, Inc.

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