A model and empirical test of the strong form efficiency of US capital markets: more evidence of insider trading profitability

This manuscript develops a model of security market trading and uses binomial probabilities to examine insider trading behaviour. The informed trader is stylized as a corporate insider who possesses privileged information by virtue of his position. We assume insiders are risk averse and information acquisition costs are effectively zero. The model shows that in an efficient, competitive market where traders do not earn profits in excess of the level commensurate with the assumed risks and costs, the elasticities of trading profits with respect to degree of risk aversion and transaction costs are equal to one. This simple proposition extends to test empirically, using a log-linear regression, whether US security markets are strong form efficient. We then extend the competitive market model by relaxing various assumptions. The result of this extension is that the elasticities of the insiders' profit with respect to risk aversion and transaction costs are not jointly equal to one. This hypothesis is examined using US SEC recorded insider purchases and sales of securities and transactions market data. There are numerous assumptions in the model development and empirical execution, that may have implications for generalizing these results. However, the null hypothesis that US security markets are strong form efficient is easily rejected. This can be interpreted as more evidence of profit potential for insider traders, despite the fact that approximately 40% of the insider transactions examined here were deemed unprofitable.