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Published August 28, 2017 | Submitted
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Investment and Insider Trading


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.

Additional Information

The first two authors are grateful to the SSHRC for financial support. We would also like to thank the Vancouver Stock Exchange for financial support. We wish to thank Jonathan Berk, Bob Dammoni Merwan Engineer, Paul Fischer, Rick Greeni Praveen Kumar, Huw Lloyd-Ellis, Ted Neave) Gregor Smith, Chester Spatt, Raman Uppal, participants at the 1992 Western Finance Association Meetings, the 1991 Canadian Economic Theory conference, the 1991 Pacific Northwest. Finance conference and finance seminars at Carnegie Mellon University, MIT and UBC for useful comments. The usual disclaimer applies. Published as Bernhardt, Dan, Burton Hollifield, and Eric Hughson. "Investment and insider trading." The Review of Financial Studies 8, no. 2 (1995): 501-543.

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August 20, 2023
August 20, 2023