INSIDER AND LIQUIDITY TRADING IN STOCK AND OPTIONS MARKETS

We analyze the introduction of a nonredundant option, which completes the markets, and the effects of this on information revelation and ris k sharing. The option alters the interaction between liquidity and ins ider trading. We find that the option mitigates the market breakdown p roblem created by the combination of market incompleteness and asymmet ric information. The introduction of the option has ambiguous conseque nces on the informational efficiency of the market. On the one band, b y avoiding market breakdown, it enables trades to occur and convey inf ormation. On the other hand, the introduction of the option enlarges t he set of trading strategies the insider can follow. This can make it more difficult for the market makers to interpret the information cont ent of trades and consequently can reduce the informational efficiency of the market. The introduction of the option also has an ambiguous e ffect on the profitability of insider trades, which can either increas e or decrease depending on parameter values.