Insider Trading Rules and Price Formation in Securities Markets - an Entropy Analysis of Strategic Trading

Abstract

This paper addresses the issue of how insider trading rules affect price formation in securities markets and suggests the application of information theory to market microstructure theory. We analyze a variant of Kyle's (1985) setting by simply introducing a more general criterion for informational efficiency borrowed from information theory - namely maximum information transmission. The analysis shows that both the insider's optimal trading strategy and the market price of the risky security depend on the insider trading restriction. Insider trading restrictions are reported to be detrimental to the liquidity of the securities market. We find that a unique insider trading rule exists which implements semi-strong form informational efficiency of the securities market. Alternative restrictions on insider trading give rise to either underreaction or overreaction in securities prices. Too strict insider trading rules are shown to account for excess volatility in securities prices. Contrary to common notion, the uninformed investors are shown to be hurt by too restrictive insider trading rules. We conclude that loose insider trading rules are preferred by the group of investors as a whole.

Keywords: Insider trading rules, informational efficiency, underreaction, overreaction, excess volatility, information theory

JEL Classification: G14, D82