Feedback Effects, Asymmetric Trading, and the Limits to Arbitrage

67 Pages Posted: 21 Mar 2011 Last revised: 29 Oct 2018

See all articles by Alex Edmans

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 ; National Bureau of Economic Research (NBER)

Wei Jiang

Emory University Goizueta Business School; ECGI; NBER

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, European Corporate Governance Institute (ECGI) - Finance Working Paper No. 318/2015, Available at SSRN: https://ssrn.com/abstract=1787732 or http://dx.doi.org/10.2139/ssrn.1787732

Alex Edmans (Contact Author)

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Itay Goldstein

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