Abstract Agency theorists consider a firm as a nexus of contractual relationships. Contracting parties such as shareholders, debt holders, managers, input suppliers, advertising agencies and retailers may have information superior to outsiders concerning the firm's quality. In this paper, we show that the duration of contractual relationship within a firm has important implications on the dynamics of the price and trading volume of the firm's stock. If the duration of information asymmetry corresponds to that of contractual relationship, insiders with long-term relationship is shown to marginally prefer less aggressive trading strategies than those who can only access superior information temporarily. Such behavior makes it more difficult for the market maker * Address for correspondence: Ying-Ju Chen, phone: 212-998-0489, e-mail: [email protected], address: 44 W 4th Street, KMC 8-151, New York, NY 10012 1 to infer the existence of informed traders. The market maker will henceforth provide narrower bid-ask spreads, which attract discretionary liquidity traders to gather their trades in that period. With the long-term contractual relationship, uncertainty is resolved more slowly because the insider trades on her information advantage gradually. The long-term relationship also enlarges the liquidity traders' loss and discourages them from holding the firm's stock, and therefore reduces the amount of proceeds that the entrepreneur gathers when she makes financing. On the other hand, with the long-term relationship, a more efficient effort level can be expected, and thus the outcome of the investment plan will be higher. We conclude that the entrepreneur's profit as well as a firm's fundamental value will be influenced by the duration of the firm's internal contract. The optimal contractual duration depends on the adverse selection cost and the investment efficiency
