Feedback Effects, Asymmetric Trading, and the Limits to Arbitrage
London Business School - Institute of Finance and Accounting; University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)
University of Pennsylvania - The Wharton School - Finance Department
Columbia Business School - Finance and Economics
April 27, 2015
American Economic Review, Forthcoming
AFA 2013 San Diego Meetings Paper
ECGI - Finance Working Paper No. 318/2011
We analyze strategic speculators' incentives to trade on information in a model where firm value is endogenous to trading, due to feedback from the financial market to corporate decisions. Trading reveals private information to managers and improves their real decisions, enhancing fundamental value. This feedback effect has an asymmetric effect on trading behavior: it increases (reduces) the profitability of buying (selling) on good (bad) news. This gives rise to an endogenous limit to arbitrage, whereby investors may refrain from trading on negative information. Thus, bad news is incorporated more slowly into prices than good news, potentially leading to overinvestment.
Number of Pages in PDF File: 61
Keywords: Limits to arbitrage, feedback effect, overinvestment
JEL Classification: G14, G34
Date posted: March 21, 2011 ; Last revised: May 2, 2015
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