Insider Trading, Earnings and Stock Based Compensation: A View to Speculation

Abstract

We design a laboratory experiment to study the relation between earnings management and insider trading and their effects on the stock markets. The experiment simulates a market where one insider and three outsiders trade on the stocks of a company. We show that if the insider affects the stock price with her earnings announcements, then she will use this power and increase her capital gains. These earnings management practices not only induce price inefficiencies but also negatively affect the profits of the other traders. We also show that the managerial stock-based compensation worsens these effects, seriously increasing stock prices and manager’s profitability. We conclude that the lack of transparency in earnings management and the perverse incentives of the managerial compensation policies have an important role in generating price inefficiencies, bubbles and financial crises.