Insider Trading, Investment, and Liquidity: A Welfare Analysis


  • Sudipto Bhattacharya,

  • Giovanna Nicodano

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    • London School of Economics and Political Science and CEPR, and Università degli Studi di Torino respectively. We are grateful for financial support from the Ente Einaudi, the Italian MURST, and the International Centre for Economic Research (ICER), Torino. It is a pleasure to acknowledge the excellent research assistance of Giacomo Elena. Work on this paper was begun while Bhattacharya was a Visiting Fellow at ICER during the Summer of 1995. We wish to thank, without implicating in errors, Gabriella Chiesa and Jose Marin for advice and encouragement, and participants at seminars at the Universities of Brescia, Roma “Tor Vergata”, Tilburg, Torino, the CEPR Conference on “Information, Financial Intermediation and the Macroeconomy” Alghero 1997, as well as an anonymous referee and the editor René Stulz for their very helpful comments and suggestions.


We compare equilibrium trading outcomes with and without participation by an informed insider, assuming inflexible ex ante aggregate investment choices by agents. Noise trading arises from aggregate uncertainty regarding other agents' intertemporal consumption preferences. The welfare levels of outsiders can thus be ascertained. The allocations without insider trading are not ex ante Pareto efficient, because our model differs from standard ones with negative exponential utility functions and normal returns. We characterize the circumstances under which the revelation of payoff-relevant information via prices—arising from insider trading—benefits outsiders with stochastic liquidity needs, by improving risk-sharing among them.