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"Can financial markets ever be considered to be truly efficient; given that insider trading is prohibited in a number of jurisdictions? Further, what might have been the pitfalls and the benefits of relaxing insider trading prohibitions?

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Introduction

´╗┐Front page AC32820 ? Financial markets and institutions assignment Total word count - 1984 Assignment Question: "Can financial markets ever be considered to be truly efficient; given that insider trading is prohibited in a number of jurisdictions? Further, what might have been the pitfalls and the benefits of relaxing insider trading prohibitions in the context of the recent (and on-going) difficulties and uncertainties in financial markets?" This report has been undertaken to consider whether financial markets can ever be truly efficient, with specific relation towards insider trading and the connotations different proposals on the regulation of this activity could have on the on-going difficulties and uncertainties in the financial markets at present. To explain some of the fundamental terms this report will be discussing; A financial market is any market place that allows traders to buy and sell financial assets such as bonds, shares, commodities, currency?s and derivatives. They are typically defined by having transparent pricing, basic regulations on trading, costs and fee?s and market forces determining the prices of securities that trade. Examples of financial markets include the New York stock exchange (NYSE) and the forex markets. ...read more.

Middle

and intrinsically involves profiting from a breach of confidence. However, there is also an argument that insider trading increases market efficiency by allowing this secret information to influence prices, and therefore improve the efficiency within the markets; some form of leakage is required to bring markets anywhere near the strong form efficiency. The penalties on those individuals/groups found guilty of participating in this act are becoming ever more severe, as shown in the recent hedge fund titan Raj Rajaratnums case, with the prison sentence reaching double figures [3]. Insiders who wish to exploit price sensitive information tend to collaborate with traders to make it harder to trace the trades back to the individual who is known to have access to the information, this is referred to as an inside ring. The fact that insider trading has been criminalised implies that excessive returns could be made from trading on this inside information and as such, the strong form hypothesis can be rejected. Given that insider trading is prohibited, it is difficult to see how a market can ever be truly efficient as prices with this lack of information, wont fully reflect their actual value; this completely highlighted by the Enron case with bribes and bad practice used to propel its share price way above its actual value.[7]. ...read more.

Conclusion

Investors could have still bought the CDO?s due to their inaccurate credit ratings showing them as low risk, high reward investments. In conclusion, with this in mind there is a stronger argument that relaxing the insider trading laws could have had a potentially greater benefit to the economy than leaving them as they are (prohibited). The cost benefit analysis of relaxing the laws on insider trading ultimately might show that this could lead to a rise in insiders using this change in the law to their advantage, however by doing so they would be also be moving the market prices a lot closer to their real value?s for the millions of other investors in the market (whose numbers greatly outweigh those with the inside information), and therefore making the market more efficient for everyone. Instead of regulating inside trading, perhaps a change of approach to a taxation of the activity is needed, this resulting in the market prices being much more accurate and people with the inside knowledge being taxed on their excess gains so they don?t make consistent abnormal returns which would be extremely unfair on other investors [8]. [1] Kenneth lay Enron scandal - http://www.msnbc.msn.com/id/12968481/ns/business-corporate_scandals/t/lay-skilling-guilty-nearly-all-counts [2] Blake, D., Financial market analysis, 2nd Edition, pg 389. [3] http://www.efinancialnews.com/story/2011-10-13/tougher-insider-trading-sentences [4] http://www.investopedia.com/ask/answers/08/random-walk-theory.asp#axzz1cYN06nDH [5] http://static.twoday.net/mahalanobis/images/randomwalk.gif [6] http://www.npr.org/blogs/money/2010/08/26/129454550/inside-the-sausage-factory-how-wall-street-made-the-financial-crisis-worse [7] http://news.bbc.co.uk/1/hi/business/1780075.stm [8] Insider trading: regulation or taxation? Javier Estrada report April1996. ...read more.

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