Tuesday, January 14, 2014

Insider Trading Happens

Comment I posted on "A Free Market Approach to Insider Trading" by Fernando Herrera-Gonzalez:
Insider trading happens. If that were not the case, there would be no need for laws, regulations and discussions about how best to deal with insider trading.

Any seller or buyer of stock has some probability that the other party to the transaction has insider knowledge and has a better sense of the true price. The insider will engage in the transaction if the unreleased information indicates to the insider that there is positive or negative value in the stock not reflected in the price. The insider will accordingly buy or sell stock to monetize that unperceived value.

We have an asymmetric information situation, otherwise known as the used car lemon problem.

Since participants in the market know some percentage of buyers and sellers have more current, better, inside information, the market price will reflect the increased risk. Stock markets reflect higher risk through wider bid ask spreads and from higher discount rates (higher risk premiums) used on future expected cash flows and dividends. There will also be more price volatility reflecting the different opinions on whether particular trades are occurring with or without inside information.

In anonymous market transactions, buyers fear sellers have insider information and sellers fear buyers have insider information. Sellers will have to accept a lower price that accounts for the expected negative value of the seller's inside information. Likewise, buyers will have to accept a higher price that accounts for the expected positive value of the buyer's inside information.

Stock markets are pricing in the possibility of insider information. If markets believe certain industries or company executives are more or less frequently engaged in trading on insider information than on average, the market will adjust the risk premium and pricing of that industry or company stock to compensate for the additional inside information effect on the stock price.

Since insider trading occurs and market prices in aggregate are adjusting for insider trading, the purpose of laws prohibiting insider trading is neither to prevent insider trading nor to improve market pricing. The purpose of insider trading prohibitions is to preserve and increase the public and participants' trust in the market. It is political theater. It is similar to the airport security scans we tolerate at airports. It makes us feel safer, but it does not lower the probability of the actual feared event happening.

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