In order to clarify the economic rationale for the argument that insider trading undermines the "confidence" in financial markets, this paper studies the effects of insider trading on ex-ante investment in an infinite horizon overlapping generations economy. The analysis of the (multiple) steady state equilibria of this economy focuses on the effects of asymmetric information on price volatility, risk premia and the cost of capital. In an infinite horizon model one can separate the analysis of the effects of early release of information due to insider trading from the analysis of asymmetric information per se. The paper argues first that in an economy with low interest rates, investors are indifferent between the premature arrival of new information and no information at all, because the decrease of dividend risk is compensated by the increase of price risk. Having isolated the effects of early information revelation, the paper shows that insider trading decreases market liquidity and hence increase price volatility, risk premia and the cost of capital. The paper also discusses the implications of these results for the regulation of insider trading. A disclose-or-abstain rule may actually be counterproductive in the sense that it reduces market liquidity and increases price volatility and the cost of capital.
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