Feedback Effects 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
September 12, 2014
ECGI - Finance Working Paper No. 318/2011
AFA 2013 San Diego Meetings Paper
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 on private information reveals this information to managers and improves their real decisions, enhancing fundamental value. While this feedback effect increases the profitability of buying on good news, it reduces the profitability of selling on bad news. Hence the feedback effect contributes to an endogenous limit to arbitrage, whereby investors may refrain from trading on negative information, and so bad news is incorporated more slowly into prices than good news. This has potentially important real consequences -- if negative information is not incorporated into prices, inefficient projects are not canceled, leading to overinvestment.
Number of Pages in PDF File: 42
Keywords: Limits to arbitrage, feedback effect, overinvestment
JEL Classification: G14, G34
Date posted: March 21, 2011 ; Last revised: September 24, 2014
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