Michael J. Fishman

Insider Trading and the Efficiency of Stock Prices

We analyze several aspects of the debate on insider trading regulations. Critics of such regulations cite various benefits of insider trading. One prominent argument is that insider trading leads to more informationally efficient stock prices. We show that under certain circumstances, insider trading leads to less efficient stock prices. This is because insider trading has two adverse effects on the competitiveness of the market: it deters other traders from acquiring information and trading, and it skews the distribution of information held by traders toward one trader. We also discuss whether shareholders of a firm have the incentive to restrict insider trading on their own.

Optimal Long-Term Financial Contracting with Privately Observed Cash Flows

We characterize the optimal long-term financial contract in a setting in which a risk-neutral agent with limited capital seeks financing for a project that pays stochastic cash flows over many periods. These cash flows are observable to the agent but not to investors. The agent can be induced to pay investors via the threat of the loss of control of the project. After solving for the contract as an optimal mechanism, we demonstrate that it can be implemented by a combination of equity, long-term debt and a line of credit - very simple, standard securities. Thus our model provides a theory of capital structure, capturing both optimal debt maturity and debt vs. equity financing. Equity is issued to investors and is also used for the agents compensation. In equilibrium, the agent may default on the debt and control of the project may pass to debt holders. The optimal capital structure is robust in the sense that it is independent of the amount financed and under certain circumstances, independent of the severity of the moral hazard problem. We also show how our characterization applies to settings in which the agent undertakes hidden effort, or can alter the risk of cash flows.

The Optimal Enforcement of Insider Trading Regulations

Regulating insider trading lessens the adverse selection problem facing market makers, enabling them to quote better prices. An Optimal enforcement policy must balance these benefits against the costs of enforcement. Such a policy must specify (i) the conditions under which the regulator conducts an investigation, (ii) the penalty schedule imposed if an insider is caught, and (iii) a transaction tax to fund enforcement. We derive the policy that maximizes investors welfare. This policy entails investigations following large trading volumes or large price movements or both. Insiders caught making large trades are assessed the maximum penalty, but small trades are not penalized. Given this policy, insiders trade most aggressively on news with an intermediate price impact but refrain from trading on moderate or extreme news.