We have just completed a discussion of the elements in securities’ valuation. Some individuals try to get an upper hand in their stock selections by engaging in illegal activities. The following is a salient example.

“Insider Trading” has to do with the personal use of material nonpublic information about the future prospects of a company – whether good or bad, in order to garner an unearned profit by trading its securities ahead of any public announcements regarding the pertinent information. An “insider” is an employee, a relative, or friend of an employee. Insider trading, in the United States, is illegal. Don’t even think of it.

Is such trading, from a moral point of view, fair or not? Is it fair that an insider may have an exploitable advantage to enrich himself/herself? Is the law “correct” in making it illegal? Imagine the scenario below and respond to the questions that follow:

Suppose we focus on three parties to a series of transactions on a security at a point in time. Mr. X is interested in selling 1,000 shares of ABC corporation; Mr. Y is interested in purchasing 1,000 shares; Mr. Z, an informed corporate insider, is interested in purchasing a large block of the stock. Messrs. X and Y are small investors each of whom has personal reasons for engaging in the transaction.

In a normal market, X would sell to Y at the current price. Both parties would be satisfied at having engaged in the transaction. However, Mr. Z holds some critical information concerning the very favorable portents of the shares and wants to buy before the word gets out. His bid causes the share price to rise and thus Mr. X gets a higher price than he may have otherwise received, all else equal. No harm done.

Due to the rise in share price, Mr. Y pays more than he may have otherwise. Such possible harm may be overcome by the pending rise of the shares once the information is announced. The slight short-term harm is overcome by the longer-term profits Mr. Y shall earn. Mr. Y may nonetheless feel harmed.

However, had Mr. X known about the pending release of favorable information, he may have either waited before selling or changed his mind completely about his decision to sell. Mr. X may feel harmed.