Investment and Insider Trading

Abstract

Within a dynamic environment, this paper introduces an inside trader to an economy where rational, but uninformed, traders choose between investment projects with different levels of insider trading. When inside information has little value in future investment decisions, insider trading distorts investment towards assets with less private information, imposing net welfare costs on the economy. When an insider's private information is valuable in making future investment decisions, the net social benefit of inside trading can be positive; the resulting increases in investment efficiency due to more informative prices is enough to compensate for the distortion induced by the inside trader. When insiders receive private information more than once, insiders may trade to reveal their private information at the beginning of their relationship with the firm. This has two effects; i) more information is revealed in equilibrium and ii) there is less chance than an uninformed agent will have to trade with the insider. Both these effects reduce the investment inefficiencies associated with insider trading. As a consequence, uninformed liquidity traders prefer to trade in a market with a long-term insider. This improvement in investment efficiency, leads to a Pareto improvement - both the uninformed traders and the insider are made better off if the insider receives information more than once.

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