Real and Financial Effects of Insider Trading with Correlated Signals

Abstract

In this paper we study the real and financial effects of insider trading in a static model. In our model the insider is also the manager of a firm. Hence the insider chooses both the amount of the real output to be produced and the amount of the stock of the firm to trade. The aim of the paper is to study the relationship between financial decisions and real decisions. In particular, we examine how insider trading on the stock market affects the real output and price and how the real decision making affects the financial variables, such as the extent of insider trading, stock prices, and the stock pricing rule of the market maker. In the model, the market maker observes two correlated signals: the total order flow and the market price of the real good. The analysis shows that the insider trading by the manager leads to a higher real output and thus a lower price of the good; that stock price responds to changes in real demand while the stock order does not; that the stock price reveals more information in our model than in the existing literature; and that the insider's profits are less due to a higher information release. We also construct a compensation scheme that aligns the interests of the insider and the firm. Finally, we generalize the pricing rule set up by a competitive market maker since we have several but not necessarily independent sources of information.