Introduction
In the recent past, there has been an increased shift in investments. Most potential investors perceive the securities market as an optimal investment destination. This is because there are diverse options that are available to the investors enabling them to maximize their wealth. Despite this shift, there is a great risk considering the volatility within the financial sector. Among the risks that are faced by this sector is the chance of occurrence of insider trading. Insider trading refers to the process by which a professional within the securities market engages in unethical conduct. This occurs through a process of buying and selling securities by breaching the fiduciary duty or other trust relationship. In this way, these dealers hoard important information from the public about the securities. This culminates in the prices of the securities being affected. Therefore the main objective of this discussion is to analyze how insider trading affects either positively or negatively enterprises.
Ways in which insider dealing widens the bid-ask spread
According to John, bid-ask spread refers to the difference between the highest price for a security or other financial instruments that an investor is willing to pay and the lowest price that the seller is willing to offer (1997). Brokers within the secondary market of the stock exchange usually make their gain by widening the bid-ask spread. This means that there is a high chance of these brokers engaging themselves with insider trading where there is no information asymmetry. This is because there is selective disclosure of reliable information. For instance, by considering a company there is a possibility of some individuals having access to superior information regarding the future performance of the organization. Using this information, these individuals can use the services of the brokers to trade on the companies securities.
Depending on the performance of the listed firm within the securities market, these individuals can sell these securities if the information they have indicates that they will make a capital gain upon sale. If there is a perception that there will be a capital loss, they will not release the securities to be traded within the stock exchange market. This means that these individuals are using information related to the securities whereas it is not reflected in the current price of these securities.
The first effect of using this information by the parties is that the market price will first respond by moving towards the best-estimated price of the securities, which improves the market pricing efficiency. This means that such individuals make a lot of profit by involving themselves in insider dealing. Insider trading results in the prices moving away from their accurate point since artificial pressure is exerted on the prices of the securities making them move upwards.
To counter the effect of insider trading, the market maker who is either a broker, dealer, or investment firm who takes the risk of trading in the securities as the principal, responds by widening the bid-ask spread. Insecurities market there are competing market makers, at the equilibrium price, the market makers set a price for the securities at a point where the expected profit is zero on each transaction (Mervyns 1988).
Effect of widening the bid-ask spread on the cost of capital and investment
The widening of the bid-ask price hurts the cost of capital which is the interest rate hence affecting other investments, especially the financial securities. Investment is affected because portfolio managers and other investment consultants design their portfolios in a manner that fits the investors’ needs. These professionals use the bid-ask spread to determine the fair value of the asset at the time of quotation. The price that is quoted as the asking price for the securities is inclusive of the premium for the immediate buyers of the securities. The bid price includes a price that the buyer is willing to pay for the security. This means that the investors can use the bid-ask spread to determine the liquidity of the investment (Sergey &Michael, 2002).
The widening of the bid-ask spread leads to the investors demanding an increase in their rate of return. This can be detrimental to the firm since the firm will be forced to decline the volume of reserves that it had initially set. To the firm the cost of investment increases since there will be a reduction in the volume of reserves which is a costless source of finances for the firm. The main reason why the investors demand an increase in their rate of return is to protect their investments in financial securities from loss resulting from insider trading.
Open capitals market discourage market securities research
Due to the current financial crisis that is being experienced globally, there is an inclination of the financial sector to undergo a financial architecture, especially the capital market by adapting the open capital market. Open capital refers to a concept where there is complete liberalization of the capital market globally. This increases the investment opportunities available to the investors since the diversification avenues increase.
Adoption of the open capital market would have adverse effects on the research for the securities market. This is because countries with open capital markets experience a lower rate of growth in the variability of the securities than countries with the closed capital market. This is because there is an increase in volatility within the securities markets. Through the adoption of an open capital market, the securities market becomes globally integrated. This increases the degree of complexity involved in the research of the securities markets since there are a lot of dynamics that are involved that have to be considered.
Through the open capital markets, there is an increase in the level of risk involved. This is as a result of the arising of the concept of international risk which further makes the research for the securities market to be more complex. Due to globalization, the securities markets have become integrated which means that the performance of securities is affected by the operations of other financial markets dealing with related securities due to the enhanced flow. This signifies an enhancement of the concept of risk-sharing owing to the increased degree of integration within the securities market.
Ways in which open markets destroy the opportunities for risk-sharing
Through the adoption of the open capital market, the concept of international risk sharing is achieved. This is because there are no restrictions related to the scope of operation of the securities markets. The concept of international risk sharing is supposed to reduce the complexities of research for the securities market and increase welfare. The adoption of the open capital market limits the chances of opportunities available for the success of the concept of risk-sharing. This is because open capital market leads to increased market imperfections. One of the market imperfections that are common in the securities market is related to information asymmetry leading to insider trading. This is because some parties can gain due to the unethical competitive advantage that they have. Others lost in the process of trading in the securities market due to these market imperfections. (Geert et al, 2003).
The concept of international risk sharing is also not achieved due to the existence of home asset preference. The open capital market ensures that foreigners can conduct investments in securities within foreign countries. In most instances, the investors prefer to invest in securities that are offered within the domestic market. This is because some of the investors are risk-averse and would not prefer to invest in securities of other countries through the open capital market as a diversification strategy.
According to Geert et al, there is also the existence of incomplete insurance markets. Insurance markets are supposed to enhance the concept of risk-sharing of the open capital markets. This is because insurance companies are one of the investment destinations for securities. A well-developed insurance market ensures that the degree of diversification of investment increases. The insurance market is incomplete in the sense that they do not offer divergent policies to mitigate losses that occur in the course of trading in the global securities market. This means that a well-developed insurance market can result in the advancement of the concept of international risk sharing about the open capital market (2003).
Free rider problem
In organizations, there is a possibility of the executives benefiting using the financial investments of the shareholders. This is illegal and it is referred to as a free-rider problem since the shareholders are not able to monitor the operations of their investments. The executives such as the directors are supposed to maximize the wealth of the investors. This is because the relationship that exists between the investors and the executive is that of the agency. If the shareholders note that the executives are involving themselves with a breach of the trust relationship by engaging themselves with free-riding such as undertaking insider trading, they have an option on how to eliminate this problem.
One of the mechanisms that they can undertake is engaging in the organization in a takeover (Sanford and Hart, 1964). This is where the entire management of the firm is completely overhauled either through hostile or friendly means.
In conclusion, insider dealing leads to widening of the bid-ask spread which affects the price of the security. This results in a loss on the part of the investors since they are denied paramount information relating to their investments. Due to the volatility of the securities markets, there is need for a conclusive research to be conducted before implementing the open capital market. This will ensure that the risks of failure are minimized. The shareholders should ensure that they effectively monitor the activities of the directors to ensure that they do not involve themselves with insider trading. This can help in the elimination of the free-rider problem.
References
- Sanford, J.S. & Hart, O.D. 1964.Take-overbids, free-rider problem and the theory of corporation. Churchill College: Cambridge.
- Melvyn K& Ailsa R. 1988. Insider trading.Oxford Publishers: London.
- Geert, B, Campbell, R.H., & Christian L. 2003. Growth Volatility and Financial Liberalization. Columbia University: New York.
- Sergey S.2002.Market perception of information asymmetry: Concentration of Ownership by different types of institutions and bid-ask spread. University of St. Thomas: New York.