Shorting the Bear: A Test of Anecdotal Evidence of Insider Trading in Early Stages of the Sub-Prime Market Crisis

This article uses trading data in the options market for shares in The Bear Sterns Companies (BSC) during the first half of 2007 during early stages of the US sub-prime crisis as a laboratory to examine the incidence of insider trading. The principal research objective is to enhance our understanding of the extent of strong form inefficiency in equity derivative markets. The presence of illegal insiders is particularly important to predictive markets as they raise transaction costs and deter participation by outsiders, which reduce the accuracy of price signals and markets' forecasting ability. We take the perspective of a regulator making use of hindsight to identify the most propitious periods for insider trades and to identify market activity that is indicative of insiders. Half the value of BSC options traded during the first half of 2007 were on 19 percent of the days, mostly in contracts in or close-to the money and near to expiry. We find persuasive evidence that insiders could have been active in trading Bear Sterns stock during this period.