Download this Paper Open PDF in Browser

Feedback Effects, Asymmetric Trading, and the Limits to Arbitrage

61 Pages Posted: 21 Mar 2011 Last revised: 2 May 2015

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department

Wei Jiang

Columbia Business School - Finance and Economics

Multiple version iconThere are 3 versions of this paper

Date Written: April 27, 2015

Abstract

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.

Keywords: Limits to arbitrage, feedback effect, overinvestment

JEL Classification: G14, G34

Suggested Citation

Edmans, Alex and Goldstein, Itay and Jiang, Wei, Feedback Effects, Asymmetric Trading, and the Limits to Arbitrage (April 27, 2015). American Economic Review, Forthcoming; AFA 2013 San Diego Meetings Paper; ECGI - Finance Working Paper No. 318/2011. Available at SSRN: https://ssrn.com/abstract=1787732 or http://dx.doi.org/10.2139/ssrn.1787732

Alex Edmans (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Itay Goldstein

University of Pennsylvania - The Wharton School - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-746-0499 (Phone)

Wei Jiang

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States
(212) 854-5553 (Phone)

Paper statistics

Downloads
730
Rank
26,612
Abstract Views
3,688