Product Market Competition, Insider Trading Regulation, and Optimal Managerial Contracts

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

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

3. 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

4. Model 1 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 Firms and managers learn about whether there are insider trading restrictions Given (qI,A,B), M choose qE Firm I choose qI Firm E offer a scheme (A,B) M observe the realized cost of firm E Stock market close, profit realized

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

6. 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).

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

8. 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)

9. 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 salary Trading gain Hedging more

10. Intuition Bull market a>0.5 1-a<0.5 more information advantage Less information advantage lower trading gain Higher trading gain Higher salary Lower salary Negative Correlated salary Trading gain Hedging less

11. 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.

12. A1 B A2 firm 1 stock Index basket Firm 2 stock Insider trading Insider trading D Firm 2 Firm 1 Compensation Scheme Compensation Scheme Output market Entrepreneur Entrepreneur consumer

13. Prisoner’s Dilemma Allowing insider trading may results in a prisoner’s dilemma, the shareholders of both firm would be made worse off.

14. 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

15. Thank you for listening The End