Question

1. XYZ Company is a publicly traded company that produces electric cars. XYZ has developed a battery that will enable cars to go from New York to San Francisco without requiring any recharge. The news of this development is known only by the CEO, Emon Rusk. The development of this new technology will change the auto industry and make XYZ company the leading force in the market. Emon Rusk wants to make money from this inside information by investing his company’s stock before XYZ Company officially announces the technology. It is sure that the stock prices will increase after public learns this revolutionary technology.

Briefly, answer the following questions;

1. If the markets are NOT efficient in strong form, is it possible for Rusk to make money by investing stocks before the announcement?

2. Suppose now Rusk discloses to the public that he is going to invest in his company? What will happen to the stock price? Why?

3. Is it ethical that Rusk invests based on private information? Why?

Answer 1

a) Strong form efficiency states that all information in a market, whether public or private, will be responsible for a stock's price. For Strong form efficiency, inspite of the amount of research investors have done, it is not possible to gain profits more than normal returns. Since, the markets are NOT efficient, it will therefore be possible to earn profits greater than normal. So the CEO, Emon Rusk can make money by investing in stocks before the announcement as he, being the CEO, will have sufficient information and knowledge regarding the new technology which will transform the auto industry and benefit company XYZ.

b) If Rusk discloses about his intention to invest in his company, the stock price rises. This will give an indication to the industry that some good development(which can be recent technology/ acquisition/ product launch, etc.) in XYZ company is about to come which has made the CEO invest his own money in it.

c) Insider trading can be:

i) Legal - When someone insider to the company buys/sell shares of the firm and these transactions are properly registered with the Securities and Exchange Commission (SEC) and done with advanced filings.

ii) Illegal - Illegal use of private material for own profit.

In this case, since Rusk  wants to invest based on private information for own profit, this is illegal and not ethical.