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

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Presentation transcript:

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

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

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

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

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

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)

Intuition a<0.5 1-a>0.5 salary Trading gain Less information advantage more information advantage Lower trading profitHigher trading profit Lower salary Higher salary Positive Correlated Hedging more Bear market Good state Bad state

Intuition a>0.51-a<0.5 salary Trading gain more information advantage Less information advantage Higher trading gainlower trading gain Lower salary Higher salary Negative Correlated Hedging less Bull market

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 firms best strategy.

Firm 1 Firm 2 firm 1 stockFirm 2 stock Insider trading Output market consumer Entrepreneur Compensation Scheme Compensation Scheme Index basket A1BA2 D

Prisoners Dilemma Firm 2 Firm1 Insider trading No insider trading Insider trading (2,2)(5,1) No insider trading (1,5)(4,4) Allowing insider trading may results in a prisoners dilemma, the shareholders of both firm would be made worse off.

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 insiders incentive to over-expand output is mitigated, the firm value is enhanced

Thank you for listening The End