Becker Meets Kyle: Inside Insider Trading

Abstract

How do illegal insider traders act on private information? Do they internalize legal risks? We address these questions using a unique sample of illegal insider traders convicted by the Securities Exchange Commission. To shed light on the traders' investment strategies, we analyze, theoretically and empirically, the tradeoff between the risk of information becoming public (information risk) and the risk of being subject to enforcement actions (legal risk). Consistent with Kyle (1985), insiders manage their trades' size and timing according to prevailing liquidity conditions, fundamental and noise volatility, and the value of the private tips they receive. Personal characteristics, such as gender, age, and profession, play a lesser role. Using various shocks to legal risk, we find that insiders internalize such risk by moderating trade aggressiveness, providing empirical support to the deterrence functionm of the regulators' actions. Consistent with Becker (1968), positive shocks to legal risk also induce insiders to concentrate on fewer private signals of higher economic value. Thus, insider trading enforcement could hamper stock price informativeness.

Keywords: Private Information, Insider Trading, Trading Strategies, Liquidity, Asset Prices, Volume, Stock Markets, Option Markets, Volatility, SEC, Financial Crime

JEL Classification: D82, D83, G14, G18, G40, G41