Insider Trading, Disclosure, and Product Market Competition

Abstract

Corporate insiders, particularly managers, not only have access to their firms' private information, but also control over their firms' operational decisions. In this paper, we consider a setting where managers manipulate the firms' real activities in anticipation of subsequent insider trading opportunities. We find these managers choose production quantities that are strictly higher than the quantities absent insider trading. The overproduction leads to lower firm profits but higher consumer surplus. When we allow the managers to trade both in their own firms' and their rival firms' stocks, we find that the competition among insiders in the financial market drives down the expected insider trading profits and their incentives to distort production decisions. We then discuss the scenario of "substitute trading" when the managers only trade in their rival firms' shares, and show that the managers can earn some insider benefits without sacrificing their firms' profitability. We also explore the possibility of endogenizing the managers' ownership through compensation contracts.