Insider Trading: The Value of Asymmetric Information Created by Tradable Securities and its Implications for Disclosure

Abstract

While tradable securities remain a popular means of compensating managers, there is constant discussion on the need for tighter regulation, including disclosure requirements, to prevent employees from actually being able to gain from trading these securities based on their private information. The purpose of this paper is to provide insights into the role and economic consequences of disclosures aimed at reducing the ability to gain from insider trading. Using the principal-agent framework I show that in some situations allowing the agent to trade anonymously on his private information increases production and, more importantly, generates a Pareto improvement compared to the case where the agent's trades are required to be publicly disclosed. The intuition for this result is that the bid-ask spread imposed by the market maker makes it costly for the agent to sell his shares and get full insurance if he has taken a low-cost action. As a consequence, the agent takes the high-cost action with higher probability, which in turn makes the overall economy better off.

Keywords: compensation packages,tradable securities,insider trading