Insider trading Flashcards
In dealership markets, dealers (market makers,
intermediaries) provide
liquidity to the market.
• They are required to maintain liquidity at all times,
and in return receive certain privileges from the
exchange
Order driven markets
In order driven markets other market participants
can also post limit orders, but market makers are
required to keep the order book filled at all times.
An order-driven market displays all the bids and asks for a security in the open marketplace or exchange.
• Examples: AEX, NYSE, LSE.
Quote driven markets
Only displays bids and asks and then meet these order out of
inventory, adjusting prices in response to
perceived demand and inventory needs. • Example: NASDAQ
In exchange for providing liquidity the market maker
receives certain privileges:
- Exemption from trading taxes
- Exemption from holding disclosure rules, etc.
- Sometimes early access to the order book
order book
an electronic list of buy and sell orders for a specific security or financial instrument organized by price level. An order book lists the number of shares being bid on or offered at each price point, or market depth. It also identifies the market participants behind the buy and sell orders, though some choose to remain anonymous. These lists help traders and also improve market transparency because they provide valuable trading information.
bid - ask spread
the difference between the buy (what you give) and sell price(what i recieve)
and thats how the market makes profit and if they have order book they can tell in what direction the prices are going at can adjust accordingly
Order vs Quote driven markets
ODM: Displays all bids and ask quotes, Orders detail the quantity and the price at which the share may be traded, No guarantee of execution Price Transparency Counterparty is Unknown
QDM:
Focuses only on bid/ask quotes of market makers
Orders only share the price for the security
Guarantee of execution
No price transparency
Counterparty is Known
Liquidity traders
Sometimes they’re also called ”Noise Traders”
- traders or investors who make decisions regarding buy and sell trades in securities markets without the support of professional advice or advanced fundamental or technical analysis. So they only rely on whats on the internet
Insiders
traders that trade on non-public material
information (”insiders”)
• They know that the true value of the asset is
above/below the current price in the market
• Thus they will submit buy/sell orders to take
advantage of their information
short selling
an investment or trading strategy that speculates on the decline in a stock or other security’s price. It is an advanced strategy that should only be undertaken by experienced traders and investors.
Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
Short-sellers bet on, and profit from, a drop in a security’s price. This can be contrasted with long investors who want the price to go up.
Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely due to margin calls.
If there were only inside traders
• Insider would fear that their trades
would reveal their information • When everybody is an insider, you fear trading
with someone with even better information
• If you’re buying, why is the other guy
selling?
• Result: a No Trade equilibrium.
• The information traders need the liquidity
traders to hide behind.
Market maker
A market maker is an individual participant or member firm of an exchange that buys and sells securities for its own account.
Market makers provide the market with liquidity and depth while profiting from the difference in the bid-ask spread.
Brokerage houses are the most common types of market makers, providing purchase and sale solutions for investors.
Market makers are compensated for the risk of holding assets because a security’s value may decline between its purchase and sale to another buyer.
Info asymmetry for MMs
• They do not know whether the client is an
information trader or liquidity trader
Copeland and Galai model
• In order to limit the losses due to insiders, and
to compensate with extra profits from liquidity
traders, market makers will increase their bid-ask spread whenever they suspect that
insiders are active.
bid price
the highest price someone is willing to pay
ask price
the lowest price someone is willing to sell for
In the Copeland and Galai model insiders are
uniformly “bad”:
• They increase the cost of trading for liquidity traders
• Reducing average uninformed traders ability to
engage in welfare increasing trades (so hurts Pareto
efficiency)
• MM and liquidity traders would like to buy and sell
shares to each other at a fair price, but are not able
to due to insiders.
• Insiders do not even increase the informational
effectiveness of the market
• But effect of insiders in this model is also limited due to the
single-trade condition
rule of disclosure or abstain
An insider in possession of material nonpublic
information must disclose such information before
trading, or if disclosure be impossible or improper,
must abstain from trading in that company’s stock
It even applies to non-directors, incl. people outside the company.
The more inside traders
• The bigger the bid-ask spread
• But also the bigger the ’jumps’ towards the
true value
• i.e. the quicker the market converges to
the true equilibrium price
Insiders can play a larger role especially in the case of
small companies, where liquidity trades are less frequent, asymmetric info is larger
2 perspectives on insider trading
One perspective is that for short-term, high volatility
situations (e.g., take-over rumours), insider trading is
mostly costly, while providing little benefit.
• Over the long term the benefit of insiders pushing prices
closer to fundamental values may outweigh the cost.
Is there real economic damage from mispriced
shares?
even the firm itself might be
uncertain about it’s own value. If a well-functioning truth-revealing secondary market can
reveal the true value of the firm this can give
guidance to which capital investments are
profitable and which are not.
• Another reason is that it is often optimal from
principal-agent perspective to tie the remuneration
of the firm’s managers to the firm’s value. But for
this to be optimal you need an accurate signal of
the firm’s value.
• Finally aggregate market prices such as the stock
market index and the yield curve inform monetary
policy makers on setting optimal interest rates.
Manne (1966) argues that insider information is a
’victimless crime’:
• Insider buyers push up the price, resulting in
liquidity sellers receiving a better price than they
should.
• Insider sellers push the price down, resulting in
lower prices for liquidity buyers.
However if the seller would not have sold to the
informed trader, she would have just sold to another
liquidity buyer, who would have then eventually made
the profit.
…and the same for the liquidity buyer.
Liquidity traders as a group lose out to the insiders.
One problem with insider regulation is that it has
”victims but no plaintiffs”:
• It is difficult to prove that you were the specific
victim of an insider trader.
• Therefore mostly dealt with through criminal rather
than civil law
In the US, the SEC has the power to bring a civil
suit against
insiders on behalf of investors.
• And if you can show you were trading around
the time the insider trading happened, you
can become party to the suit.
Public information or ’Information Generally
Available’ is information that
(1) has been released,
(2) has likely reached the people that typically trade
in the relevant security, and (3) enough time has
elapsed
The most obvious candidate for insider traders are
directors and employees of a firm. Typically these
trades always need to be disclosed, and insiders are not
allowed to trade based on ”material non-public
information”. In particular they are not allowed to buy
and sell their own shares within a 6 month period.
Rozeff and Zaman (1988) show that it is possible for
outsiders to earn
abnormal returns by copying the
trades of insiders.
Givoly and Palmon (1985) suggest that insiders
actually earn
more money due to the market reaction to
their disclosed trades, than due to the inside
information itself.
As soon as you become an insider, you are
+ Problem
barred from
trading in any relevant securities.
• Even if a broker or market maker becomes aware of a
piece of insider information, they are legally barred
from trading that security
• Problem: Large activist shareholders can
accidentally become insiders and then lose some
of their leverage over the firm, as they are no
longer allowed to sell off their position within six
months of acquiring their stocks.
As insider trader you are also barred from
to ’procure’ anybody else
(friends, family) to do your trading for you.
• Applies whether you are benefiting from the
information or not: Even if you buy after receiving
’bad’ insider information, you are still in violation.
• You are also barred from tipping:
• You are not allowed to directly or indirectly
communicate the information to any other
person if you know or should know that the
other person could or would be likely to trade on
this information
Chinese walls
• A separation between separate departments of a
firm such that information cannot flow from one
side to the other
• Typical example: investment banking and
brokerage arms of the same bank
• Initially Chinese Walls were voluntary, but later the
SEC made it mandatory in 1988.
• In the wake of the Enron scandal, Sarbanes-Oxley
made the separation even more stringent (e.g.
banning sell-side bonuses)
First federal regulation with the SEC act of 1934
Banned
“any manipulative or deceptive device or contrivance used or
employed in connection with the purchase or sale of
registered or unregistered securities”
• Specifically banned “short-swing profits”, i.e.
making a profit by buying and selling within 6
months.
• But wasn’t very specific about what’s an insider,
what is a
• manipulative or deceptive device, etc.
• All additional regulation came from jurisprudence
and SEC rule making.
• But quite limited in scope (mostly only directors),
had to prove intent and actual fraud.
This was followed by the disclose or abstain rule
Insider
Trade Sanction Act (1984)
• Imposing treble damages and increasing the
maximum fine.
• In 1988 a maximum jail time of 10 years
and a fine of $1 million was established
Fair Disclosure Regulation (or reg FD).
• Limits especially selective disclosure to large
shareholders, chosen analysts.
EU: Market Abuse Directive 2014/57/EU
• Illegal to trade on material non-public
information, or to communicate it with
others.
• Issuers of financial instruments have to reveal
relevant material information as soon as
possible (unless against ’legitimate interests’.)
• Also have to immediately publish changes to
previous disclosures.
• Firms can’t disclose information to selective parties.
• Unless for professional purposes to persons
owing a duty of confidence to the company
AFM distinguishes 2 type of insiders
• Primary insiders are all directors, lawyers,
accountants, etc. that are presumed to have
knowledge of the relevant material non-public
information. The actual knowledge of insider
information doesn’t need to be proven.
• Secondary insiders applies to anyone else that
somehow learned insider information and traded
afterwards. In this case the AFM needs to prove
that you did in fact acquire such information.
AFM: Exemptions
When the trade occurs due to pre-existing
derivative obligations, share buyback programs, at
expiry date of employee option schemes, dividends
in the form of shares, major shareholders during a
takeover, departments shielded by Chinese Walls.
AFM: Firms need to maintain
lists of people who are
presumed to have insider information. People on this
list have report any trading to the AFM within 4
days
Copeland and Galai Model:
Assumptions and EV
-> single trading period, value is realized at the end of period
Expected value: µ = p𝑉𝐻 + (1 − p) 𝑉L
q = insiders 1-q = liquidity traders, they only know the probability p of V=VH
- > traders only buy/sell a single stock
- > zero profit MMs
- > MMs also only know p, VH and VL: no inside info
- > MMs quote ask price pa and bid pb
MMs need to have an inventory of
every single stock
on the market that their clients may want to buy,
but they don’t want to hold too much of any stock
either (just adds risk), so inventory management is
very important to the MM.
• MM balances the inventory after the trading period:
When they buy a stock today, sell a stock tomorrow.
When they sell a stock today, buy a stock tomorrow.
Copeland and Galai Model:
ask price
if V = VH and MM sold the stock for pa< VH, MM needs to buy the stock the next day for VH and thus make loss of - (VH - pa)
if V= VL and MM sold for pa>VL, they make profit of (pa-VL)
On average MM makes profit of 𝑃𝑎 − 𝜇*n sales assuming no insiders
Copeland and Galai Model:
bid price
If V = 𝑉𝐿 and the MM bought the stock for
𝑃𝑏 > 𝑉𝐿 , MM makes a loss −(𝑷𝒃 − 𝑽𝑳)
• And if V = 𝑉𝐻 and the MM bought the stock for 𝑃𝑏
< 𝑉𝐻 , the MM makes a profit 𝑽H − 𝑷𝒃
• So on average MM makes a profit of µ − 𝑃𝑏 on buys.
Assuming there are no insiders
Copeland and Galai Model:
Insiders behavior
Insiders already know what the price will be tomorrow,
so they only buy when V = 𝑉𝐻 and they only sell when
V = 𝑉𝐿.
• For any 𝑃𝑎 < 𝑉𝐻 the MM will face a loss
−(𝑉𝐻− 𝑃𝑎) from each insider buyer
• For any 𝑃𝑏 < 𝑉𝐿 the MM will face a loss
−(𝑃𝑏 − 𝑉𝐿) from each insider seller
Copeland and Galai Model:
Liquidity traders
• For any 𝑃a> µ the market maker will make an
expected profit of 𝑃a − µ from uninformed
buyers
• For any 𝑃b < µ the market maker will make an
expected profit µ − 𝑃𝑏 from uninformed sellers
Copeland and Galai Model:
0 profit condition
Zero profit condition for MM mandates that 𝑃𝑎
and 𝑃𝑏 are set such that the gains from the
uninformed traders cancel out the losses on the
informed traders
Copeland and Galai Model:
Earnings for the MM rearranged
Pa = 𝜇 + 𝑞(𝑉𝐻 − 𝜇)
Pb = 𝜇 + 𝑞(𝑉L − 𝜇)
Copeland and Galai Model:
Spread
𝑆 = 𝑃𝑎 − 𝑃𝑏 = 𝑞(𝑉𝐻 − 𝑉𝐿)
Copeland and Galai Model:
Spread is increasing in
• Value spread: the bigger the value spread the
bigger the bid-ask spread
- >The more uncertainty the bigger the
potential losses of the MM to the insiders, and
so the larger the bid-ask spread.
• Number of insiders q: the more insiders the bigger
the spread:
-> Increasing the spread both lessens the losses
from the insiders and increases the gains from
the liquidity clients
-> For q = 1 bid-ask spread widens all the way to
the value spread
Glosten and Milgrom (1985) Model
• When there are a lot of buy orders: Update
(increase) the subjective probability 𝑝 that the
value is 𝑉𝐻!
• When there are lots of sell order: Update
(decrease) the subjective probability 𝑝 that the
value is 𝑉𝐻
Glosten and Milgrom (1985) Model:
The more insiders
• The bigger the bid-ask spread
• But also the bigger the ’jumps’ towards the
true value
• i.e. the quicker the market converges to
the true equilibrium price
Glosten and Milgrom (1985) Model:
Info acquisition
if information acquisition is costly, insider profits
could aid in ensuring that sufficient research takes
place.
• Suppose traders could acquire information at a
cost c
• The expected profit from being an insider equal
𝜋 = 𝑝(𝑉𝐻 − 𝑃𝑎) + (1 − 𝑝)(𝑃𝑏 − 𝑉𝐿)
• So invest in information if 𝑐 ≤ 𝜋
