Product Market Competition Insider Trading Regulation and Optimal

Product Market Competition, Insider Trading Regulation, and Optimal Managerial Contracts Chyi-Mei Chen Chien-Shan Han

Background Optimal managerial Compensation Scheme Risk neutral Entrepreneur Risk averse Information advantage Manager/ insider profit New entrant Stock Market Insider trading Shareholder Regulation? Product Market Rival Firm incumbent

Model 1 ¡ ¡ ¡ I (incumbent firm) and E (entrant) produce a homogeneous good and engage in a quantity competition. The unit cost for firm E is random, a low unit cost 1 -a high unit cost The unit cost for firm I is fixed at Demand Curve Risk-averse manager Linear compensation scheme

Model 1 Stock market open, market makers post bid and ask prices. M can submit orders. Liquidity trader Firms and managers Firm I prob b Firm El. Givena(q. I, A, B), share learn about whether Mbuy offer observe M choose q. E there are choose q. I sell l share Stock market insider prob s scheme (A, B) trading prob 1 -b-s the realized close, profit restrictions no of firm E trade cost realized

Results Risk neutral If the firm’s profit is negative correlated with the trading gain, is Optimal Scheme is B=0 B>0 Entrepreneur No insider Insider trading Manager/ insider New entrant Stock Market Shareholder Information advantage Higher firm value Risk averse Expand output Larger profit Product Market shrink output Fewer profit Lower firm value Rival Firm incumbent

Results ¡ When the manager is not too risk averse, insider trading can be value-enhancing even if the shareholders of the entrant firm must bear all the trading loss caused by insider trading. ¡ In the absence of insider trading regulation a following firm that suffer from the adverse selection problem resulting from cost uncertainty may have a higher market value. ¡ Allowing insider trading tends to raise the power of the managerial compensation scheme (B>0).

Model 1—Hedging Policy Given (q. I, A, B), M choose q. E Firms E offer a scheme (A, B) Heging is costly M choose by promising to pay the insurer in low cost state, and get a reimbursement in high cost state. M observe the realized cost

Results ¡ When insider trading is allowed, if B>0 then after making its output decision , firm E hedges more in the bear market (a<0. 5)than in the bull market. (a>0. 5)

Intuition Bear market a<0. 5 1 -a>0. 5 Bad state Good state Less information advantage more information advantage Higher trading profit Lower trading profit Higher salary Lower salary Positive Correlated Hedging more Trading gain

Intuition Bull market a>0. 5 1 -a<0. 5 more information advantage Less information advantage lower trading gain Higher salary Lower salary Negative Correlated Hedging less Trading gain

Model 2 ¡ Consider both firms facing with cost uncertainty and their shares are traded in the stock market after their managers simultaneously make output decisions and privately receive cost information. ¡ One firm indulging insider trading creates a negative externality on its rival firms, leading to a big reduction in the value of the rival firm. ¡ Allowing insider trading is always the firm’s best strategy.

A 1 firm 1 stock Insider trading Compensation Scheme Entrepreneur B Index basket A 2 Firm 2 stock Insider trading D Firm 2 Firm 1 Compensation Scheme Output market consumer Entrepreneur

Prisoner’s Dilemma Firm 2 insider No insider Allowing. Insider trading Firm 1 results in a prisoner’s trading may dilemma, the shareholders Insider (2, 2) of both firm would be(5, 1) trading made worse off. No insider trading (1, 5) (4, 4)

Implications ¡ This provides a rationale for insider trading regulation. ¡ The value of index Trading ¡ Reasons: Insiders possessing security-specific private information loses much of their information advantage if they are forced to trade the basket, which implies insider’s incentive to over-expand output is mitigated, the firm value is enhanced

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