Insider Trading Direction and Optional Wage Design
Journal of American Business Review, 3.1, 96-103, 2014
Posted: 17 Jan 2016
Date Written: December 1, 2014
This paper uses the insider trading direction as a signal to design an optimal wage contract, where the principal-agent problem due to moral hazard is resolved. Insider trading provides the corporation important information about the action of the manager. It is a tough challenge for the owners of a corporation to identify managers who will work hard and not be overly risk averse in their choices of project opportunities. Observation of the insider trading direction (buy or sell) may help to sort out superior managers. Distinguishing the quality of the managers by following their insider trading activity would help contribute to the design of an effective compensation scheme for those managers as proposed and developed in this paper. Insider purchase activities reward those managers who add value to the firm through their superior effort, better and accurate decisions, proper risk assessments and willingness to take justifiable risks. Such managers will also agree to compensation schemes partially based on their insider trading activity, since their interests will be most closely aligned with the interests of the owners of the firm. The paper presents a sound theoretical framework and develops a model for an optimal wage contract that can be utilized by the owners of the corporation. Insider trading profits are conjectured to have increased in recent years after the implementation of Rule 10b5-1. Therefore, a wage contract incorporating insider trading activity has become more relevant.
Keywords: Informed trading, Wage Contract, Compensation
JEL Classification: D82, D83, G14, G35, J33, J41
Suggested Citation: Suggested Citation