The effects of insider trading on insiders effort in good and bad times

Lucian Arye Bebchuk, Chaim Fershtman

Research output: Contribution to journalArticlepeer-review

Abstract

We analyze the effects of insider trading on insiders' effort decisions and on the value of firms. We consider a situation in which the final output of a firm and the productivity of managerial effort will depend on whether the firm is in a good or a bad state. When the state is not verifiable, the managerial contract cannot be made explicitly contingent on it: consequently, a contract that does not allow for insider trading would lead to the insiders' facing the same incentive scheme in good and bad times. Under a contract that allows for insider trading, however, insiders will buy shares on receiving (ahead of the market) good news and will sell shares on receiving bad news; consequently, they will end up facing different incentive scheme in good and bad times. Whether this effect is desirable depends on how the marginal productivity of managerial effort in good times compares with that in bad times. In particular, we show that allowing insider trading may improve managers' effort decisions and consequently may increase corporate value and benefit shareholders.

Original languageEnglish
Pages (from-to)469-481
Number of pages13
JournalEuropean Journal of Political Economy
Volume9
Issue number4
DOIs
StatePublished - Nov 1993

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