An Economic Model of Insider Trading with an Informed Third Party

Abstract

The fact that an insider gains only at the expense of an outsider, manipulative insider trading precipitates a conflict of interests. We model this conflict in an extended principal-agent framework to demonstrate that the endogenous demand for reliable information would limit the volume and persistence of manipulative insider trading. An important dimension of such an insider trading is that an insider may not always have the manipulative power and hence may rely on an informed third party for an effective manipulation. Earlier studies did not consider this possibility. We demonstrate in this new framework that the level of manipulative insider trading depends on the combination of the self-correcting market forces and the legal institutions.