Insider Trading and Real Investment

In this paper I analyze the effects of insider trading on real investment and the insurance role of financial markets. There is a single entrepreneur who, at a first stage, chooses the level of investment in a risky business. At the second stage, an asset with random payoff is issued and then the entrepreneur receives some privileged information on the likely realization of production return. At the third stage, trading occurs on the asset market, where the entrepreneur faces the aggregate demand coming from a continuum of rational uniformed traders and some noise traders. I compare the equilibrium with insider trading (when the entrepreneur trades on her inside information in the asset market) with the equilibrium in the same market without insider trading. I find that permitting insider trading tends to decrease the level of real investment. Moreover, the asset market is thinner and the entrepreneur's net supply of the asset and the hedge ratio are lower, although the asset price is more informative and volatile.