Accepted for publication August 1992
We analyze the effects of insider trading on insiders’ effort decisions and on the value of firms.
We consider a situation in which the bina! outpul of a firm anu the productivity uf managerial
effort will depend on whether
the firm is in a good or a bad state. When the state is not
verifiable. the managerial contract cannot be made expiici:!y contingent on It: consequently. a
that does not allow for insider $7ading would
lead to the insid$rs’ facing the same
incentive scheme in good and bad ?imes. elnder a contract
tha: allows for insider trading.
insiders will buy shares on receiving (ahead of the market) good news and w-i!! se!!
shares on receiving bad news; consequentiy.
ihey wrli end up faang dilferent incerxive scheme in
good and bad times, Whether
this effect is desirable depends on how the marginal productivity
of managerial effort in good times compares with that in bad times. In particular, we show thai
;R&l -7 :ra&ng EEL imrxove managers’ ekri
decisions and consequen!!! may increase
- ..a iii.ziYb.
_.3_ __ _._._. -i.= ;-,.;.--.‘.
The legal ruL qf the United States, as well as those of other advanced
limit, but do not prohibit,
is a Iutng and intensive public debate 011 wEreiher
trading. cane ~rn~oFta~t issue to
consider concerns the effects of such trading on insiders’ ex ante management
to: C&aim Fershimaii, M EDS
Northwestern University, Evanston,
IL 40208, USA.
like to thank Howard Chang arra a Chiistine
loi!s for helpfu! researc
and three anonymous
referees for helpful corn
Bshuk’s work has been provided by t
M. Olin Foundation; partial financial support
by funds granted to the Foerd