Feedback Effects, Asymmetric Trading, and the Limits to Arbitrage
67 Pages Posted: 21 Mar 2011 Last revised: 29 Oct 2018
Date Written: April 27, 2015
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: Suggested Citation