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The Effects of Insider Trading on Insiders' Choice Among Risky Investment Projects

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  • Lucian Arye Bebchuk
  • Chaim Fershtman

Abstract

This paper studies certain effects of insider trading on the principal-agent problem in corporations. Specifically, we focus on insiders' choice among investment projects. Other things equal, insider trading leads insiders to choose riskier investment projects, because increased volatility of results enables insiders to make greater trading profits if they learn these results in advance of the market. This effect might or might not be beneficial, however, because insiders' risk-aversion pulls them toward a conservative investment policy. We identify and compare insiders' choices of projects with insider trading and those without such trading. We also study the optimal contract design with insider trading and without such trading, thus identifying the effects that allowing such trading has on other elements of insiders' compensation. Using these results, we identify the conditions under which insider trading increases or decreases corporate value by affecting the choice of projects with uncertain returns .

Suggested Citation

  • Lucian Arye Bebchuk & Chaim Fershtman, 1991. "The Effects of Insider Trading on Insiders' Choice Among Risky Investment Projects," NBER Technical Working Papers 0096, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberte:0096
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    1. Lucian Arye Bebchuk & Chaim Fershtman, 1990. "The Effect of Insider Trading on Insiders' Reaction to Opportunities to 'Waste' Corporate Value," Discussion Papers 889, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    2. Mirman, Leonard J & Samuelson, Larry, 1989. "Information and Equilibrium with Inside Traders," Economic Journal, Royal Economic Society, vol. 99(395), pages 152-167, Supplemen.
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    8. Dye, Ronald A, 1984. "Inside Trading and Incentives," The Journal of Business, University of Chicago Press, vol. 57(3), pages 295-313, July.
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    1. Lucian Arye Bebchuk & Chaim Fershtman, 1990. "The Effect of Insider Trading on Insiders' Reaction to Opportunities to 'Waste' Corporate Value," Discussion Papers 889, Northwestern University, Center for Mathematical Studies in Economics and Management Science.

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