Insider Trading and the Short-Swing Profit Rule

Abstract

The short-swing profit rule is a federal statute that requires insiders to forfeit any trading profit earned from a combined purchase and sale that occurs within a six-month period. Using a multi-period strategic rational expectations equilibrium framework, I demonstrate that the rule tends to reduce both the amount of insider trading and the amount of profit earned by an informed insider from information-based trades because the rule imposes a constraint on the insider's dynamic trading strategy. Nevertheless, the rule increases the insider's welfare at the expense of uninformed investors (outsiders) because the rule inhibits risk sharing, which leads to an ex ante wealth transfer from outsiders to the insider.

Keywords: asymmetric information; insider trading; financial regulation

JEL Classification: G14, G18