This Week In Finance

Great Unsolved Mysteries in Finance (GUMFs):

Mystery no. 43: Trading by Registered Insiders: What Did They Know and When Did They Know it?

One of the continually intriguing subareas of Finance is that dealing with the purchases and sales of securities by corporate officers. Why is it intriguing? Because, presumably, these men and women have access to better information about their own companies than the rest of us, and they have access to information about their own companies sooner than the rest of us. Discussion of this unavoidable fact of life never fails to generate student interest. After a brief introduction in which insider trading is defined (something the courts have consistently refused to do, by the way), ask students about its relationship to information asymmetry, agency problems, or, relevant to this week's Discussion Starter, the Efficient Markets Hypothesis (EMH).

The Wall Street Journal runs a regular column in section C entitled "Inside Track", which follows the transactions or registered insiders in the shares of their own firms. ("Registered insiders" are corporate officers, directors, and owners of large blocks of stock in a given company - they are required to report monthly to the SEC.)

Consider the headline from the "Inside Track" column of Wednesday, September 3. "Stock Sales By Insiders Reach High: Analysts Say Tax Cut Triggered the Trades." The article indicates that the ratio of insider sales to purchases is high relative to historical norms, and an expert is quoted as saying that "the selling is getting more aggressive, which is very ominous." The same individual has, according to the article, "recommended investors place stop-loss orders on the stocks in his model portfolio."

Of course, the above suggests that trading by registered insiders is an indicator of the future direction of the market. Ask students about this notion after introducing the concepts of weak-, semistrong-, and strong-form efficiency. Under what conditions would one expect insider transactions to be valuable as indicators to outsiders (i.e., the rest of us)? Answer: If prices do not rapidly reflect new information. (Note that the key question being raised here is not whether insiders can profit from their information - numerous empirical studies extending into the 1960s suggest that is true. Rather, you are asking the students the more complex question of whether the rest of us can profits from the trading of registered insiders. The empirical results on this question are mixed, at best!)

And if insiders are acting on nonpublic information, is it information on their own firm, or on the market (hence the economy) as a whole? In either case, is society better off or worse off if insiders are restrained from acting? Finally, (and this is where I usually tie this topic to Corporate Finance), what are the implication of this information asymmetry for financial decision-makers? (Answer: signalling via dividend changes, capital structure changes, etc.!)

These are familiar questions to those who have studied the area of insider trading, but they are issues that students typically haven't stopped to consider. If you require students to read The Wall Street Journal (as I do), have them take a look at the "Inside Track" column sometime. It never fails to generate discussion, and can nearly always be linked to several areas in Corporate Finance!

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