Does Insider Trading Raise Market Volatility?

Shang-Jin Wei, Julan Du
2003 IMF Working Papers  
This paper studies the role of insider trading in explaining cross-country differences in stock market volatility. It introduces a new measure of insider trading. The central finding is that countries with more prevalent insider trading have more volatile stock markets, even after one controls for liquidity/maturity of the market, and the volatility of the underlying fundamentals (volatility of real output and of monetary and fiscal policies). Moreover, the effect of insider trading is
more » ... trading is quantitatively significant when compared with the effect of economic fundamentals. Stock markets are volatile. That is not news. But the volatility varies substantially across countries. Suppose we use the standard deviation of the monthly returns of a major market index as the measure, then the volatility in Italy is almost twice as high as in the US. The volatility in developing countries is typically even higher. For example, the Chinese and the Russian markets, respectively, are 350% and 650% as volatile as the US market. 1 Market volatility affects the incentive to save and to invest. In almost any model with a representative agent maximising utility under uncertainty, the more volatile the asset market, holding the average return constant, the less the agent will save, and hence the less the investment will be. A certain degree of market volatility is unavoidable, even desirable, as one would like the stock price fluctuation to indicate changing values across economic activities so that resources can be better allocated. However, precisely because stock prices are supposed to serve as signals for resource allocation, excessive volatility that is not related to economic fundamentals would diminish the signaling function and impede resource allocation. 2 The purpose of this paper is to assess the role of insider trading in explaining the difference in market volatility across countries. As far as we know, this has not been examined on a systematic basis. To do this, we first consider major factors other than inside trading that could also be potential explanations for market volatility. These factors can be grouped in several categories. First, the volatility of the underlying fundamentals, in particular, the volatility of the real output stream whose present discount value that the asset price is supposed to reflect, should
doi:10.5089/9781451847130.001 fatcat:qxrr4thn5fcobe2hpqv4ib6wda