I model the effect of disclosure on the tradeoff between information risk, liquidity risk, and price risk for a well-informed, risk-averse insider. Revealing some information before trading decreases the variability of the insider's information advantage and thus reduces his information risk. Disclosure also lowers adverse selection costs for market makers, which reduces the insider's liquidity risk by increasing his trading flexibility. However, disclosure increases price risk for the insider because the price fully reflects the revealed information. The reduction in information and liquidity risks outweigh the rise in price risk when the insider is less risk averse because a less risk-averse insider's information-based motive for trading is stronger than his hedging motive. The opposite relation holds when the insider is more risk averse. Therefore, a less (more) risk-averse insider experiences an increase (decrease) in welfare when he discloses some information before trading. Cost of capital and policy implications are identified.
All Science Journal Classification (ASJC) codes
- Business, Management and Accounting (miscellaneous)