The Neoclassical Theory of Investment in Speculative Markets

Abstract:     
In this paper I investigate whether firms' physical investments should react to the speculative overpricing of their securities. I introduce investment subject to quadratic adjustment costs (along the lines of Abel and Eberly [1994]) in an infinite horizon continuous time model with short sale constraints and heterogeneous beliefs (along the lines of Scheinkman and Xiong [2003]). Under standard assumptions, I show that the neoclassical q theory of investment will continue to hold despite the presence of (endogenous) speculative mispricing in the stock market. Strikingly, the welfare implications of the theory will also continue to hold, despite the presence of a speculative bubble. I show how the model provides a new formalization of the notions of short-termist and long-termist investment policies and also how the behavior of investment can be used to disentangle rational and behavioral approaches to so-called asset pricing anomalies.

Keywords: Investment, q-theory, speculation, short sales constraints, heterogenous beliefs, bubbles, mispricing

JEL Classifications: E2, G1

Working Paper Series