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Effects of Insider Trading to the Aggregate Economy I
In order to supposedly answer, or at least shed light, in the raging debate of legalizing or prohibiting insider trading, economists formulated economic models to see how insider trading positively or negatively affects the two sides of the economy. The two sides of the economy that the economists are focusing on are the aggregate economy and the effects to individual economic players. As I have said before, it is impossible for any one study, or even group of studies, to fully take into account every variable that insider trading affects. Similarly it is very difficult to measure how each individual actor is affected by insider trading. That is why in the following economic models only the aggregate economic variables of capital cost of a corporation, liquidity of the corporation's stocks, informativeness of the stock price, and investment level are being analyzed. Furthermore, the individual economic actors were grouped into four categories namely: liquidity traders, market professionals, insiders and investors. I have discussed each of these variables in my previous articles.
According to Manove, one of the effects of legalized insider trading to the aggregate economy, as shown by one of the economic models, is to increase the informativeness of the stock's price but at the same time decreasing the liquidity of the stock. The increase in the informativeness of the stock's price is explained thus: the stock's market price is the reflection of the value of the corporation; the more available the information is the more efficient and true the reflection of the corporation's value and the better the investors can gauge the status, riskyness or safety of investing in a corporation. If insiders were legally allowed to trade their company's stocks, they are injecting into the system non-public and confidential information that is material to the corporation but is not shared with the public. In effect, the insider trading makes owning and buying the stocks less risky. This injection by the insider is done through the insider's trading activity.
But other than increasing the information content of the stock price, legalizing insider trading, at least according to Manove, also decreases the liquidity of the company's stock. This may seem contradictory at first. If a stock is less risky wouldn't investors want to buy more of the stocks thereby making the stock more attractive and increasing its liquidity? The answer is yes and no. For liquidity traders, who only buy and sell stocks in the short term to answer for their liquidity needs, legalized insider trading would increase their losses in trade. Liquidity traders are not looking to hold on to the stocks they bought for a long time. They want to sell these stocks early to earn immediate profit. If insiders were trading, the liquidity traders are not equipped to trade as intelligently and to gain as much as the insiders. This would discourage liquidity traders to trade stocks. But because of this reduced liquidity of stocks, the investors and insiders would be forced to take into account the reduced liquidity and they would have to attach a liquidity discount when they purchase the stocks. This in turn would increase the cost of the company's capital.
According to Manove, one of the effects of legalized insider trading to the aggregate economy, as shown by one of the economic models, is to increase the informativeness of the stock's price but at the same time decreasing the liquidity of the stock. The increase in the informativeness of the stock's price is explained thus: the stock's market price is the reflection of the value of the corporation; the more available the information is the more efficient and true the reflection of the corporation's value and the better the investors can gauge the status, riskyness or safety of investing in a corporation. If insiders were legally allowed to trade their company's stocks, they are injecting into the system non-public and confidential information that is material to the corporation but is not shared with the public. In effect, the insider trading makes owning and buying the stocks less risky. This injection by the insider is done through the insider's trading activity.
But other than increasing the information content of the stock price, legalizing insider trading, at least according to Manove, also decreases the liquidity of the company's stock. This may seem contradictory at first. If a stock is less risky wouldn't investors want to buy more of the stocks thereby making the stock more attractive and increasing its liquidity? The answer is yes and no. For liquidity traders, who only buy and sell stocks in the short term to answer for their liquidity needs, legalized insider trading would increase their losses in trade. Liquidity traders are not looking to hold on to the stocks they bought for a long time. They want to sell these stocks early to earn immediate profit. If insiders were trading, the liquidity traders are not equipped to trade as intelligently and to gain as much as the insiders. This would discourage liquidity traders to trade stocks. But because of this reduced liquidity of stocks, the investors and insiders would be forced to take into account the reduced liquidity and they would have to attach a liquidity discount when they purchase the stocks. This in turn would increase the cost of the company's capital.
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