Insider trading and information revelation with the introduction of futures markets

a r t i c l e i n f o We establish a theoretical model with informed trading in which both of individual stock futures and its underlying stock are traded in the market. With the introduction of the futures, the paper shows that an informed trader's position of futures usually motivates him or her to trade more aggressively in the stock market at the expiration day. This also worsens the adverse selection problem and makes the stock market become less liquid. Moreover, the increase of the informed trading accelerates the information revelation and improves market efficiency on the expiration date. Finally, our results suggest that price manipulation could be one factor that affects the market liquidity and market efficiency when the futures are introduced into the market. Price discovery is one of the most important functions of the financial derivatives such as futures. Traditional financial theory argues that futures markets provide venues for investors to buy or sell an asset which will be delivered in the future, so futures prices usually reflect the fundamental values of securities and improve market efficiency. On the other hand, the introduction of financial derivatives also creates additional opportunities for strategic speculation or manipulation. The manipulation behaviors usually disturb the information environment and weaken the price discovery function of the markets. Because of the complexity of the trading strategies in derivatives markets, the impact of derivatives introduction on the market efficiency is debatable. This paper theoretically investigates the impact of the introduction of futures on the informed trader's trading strategy and the spot and futures prices dynamic. We consider a model in which a trader with private information simultaneously trades both a risky security and its corresponding futures, and discuss the equilibrium characteristics. Compared to past research that focuses on the hedging function of futures or on the low margin for speculation, this study is different as our multi-market setting pays attention to how an informed trader optimally exploits the private information in the two markets, and, furthermore, how the information reveals to the markets. The main contribution of this paper is twofold. First, we study how an informed trader optimally exploits his information to profit from an economy with both stock and its corresponding futures markets. the prices of futures and its underlying stocks move abnormally at the expiration date of the futures, because many arbitragers liquidate their holdings at that time. …