Substitute Trading and the Effectiveness of Insider Trading Regulations
48 Pages Posted: 20 Mar 2006
Date Written: October 2006
US securities laws prohibit insiders from using inside information to trade their own stocks. But it is not illegal for insiders to trade related stocks, such as stocks of their firm's competitors, suppliers, and customers. Borrowing from the law literature (Ayres and Bankman, 2001), we call insiders' trading in related stocks substitute trading. This paper studies the effectiveness of insider trading laws in the presence of substitute trading. We extend Kyle's (1985) model to a (static) model with two correlated firms, each with its own insider. We consider two different trading environments, an opaque one where the market maker observes only the order flow of the asset he makes the market in, and a transparent one where he also observes the order flow of the other (correlated) stock. We find that in transparent markets, insider trading regulations do limit insiders' ability to profit from inside information. However, in opaque markets, the regulations may actually increase insiders' profits.
Keywords: Substitute Trading, Stocks of Related Firms, Insider Trading Regulations.
JEL Classification: G14, G18.
Suggested Citation: Suggested Citation