Becker Meets Kyle: Inside Insider Trading

Abstract

How do illegal insider traders act on private information? We address this question using a unique sample of illegal insider traders convicted by the Securities Exchange Commission (SEC). 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 (legal risk). Using a regression model and various shocks to enforcement risk, we find that a subset of investors responds to this tradeoff by splitting their trades more and trading less aggressively in the presence of greater legal risk and smaller information risk. At the same time, a large fraction of traders does not internalize such a tradeoff. The insiders manage their trades’ size according to prevailing liquidity conditions, volatility of returns, noise trading activity, and the precision of the signal. Individual characteristics, such as investing expertise and age, also play an essential role. Insiders facing increasing legal risk concentrate more on information of higher 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