Insider Trading and the Problem of Corporate Agency

Abstract

This article models an economy in which managers, whose efforts affect firm performance, are able to make “inside” trades on claims whose value is also dependent on firm performance. It is shown that insider trading opportunities are a substitute for effort-assuring compensation packages. Insider-trading opportunities produce only partial effort incentives. However, they are sometimes less expensive incentive-alignment devices than effort-assuring compensation contracts, which may require payments to the manager in excess of reservation levels. Because some of the increase in value from permitting trade comes not from increased output but rather from the reduction in managerial rents, shareholders have an incentive to permit insider trade even when preventing managerial trade and paying effort-assuring compensation to managers produces greater output.

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