Information Aggregation, Investment, and Managerial Incentives

38 Pages Posted: 15 Aug 2011

See all articles by Elias Albagli

Elias Albagli

University of Southern California - Marshall School of Business; Central Bank of Chile

Christian Hellwig

University of Toulouse 1 - Toulouse School of Economics (TSE)

Aleh Tsyvinski

Yale University - Cowles Foundation

Date Written: August 10, 2011

Abstract

We study the interplay of share prices and firm decisions when share prices aggregate and convey noisy information about fundamentals to investors and managers. First, we show that the informational feedback between the firm's share price and its investment decisions leads to a systematic premium in the firm's share price relative to expected dividends. Noisy information aggregation leads to excess price volatility, over-valuation of shares in response to good news, and undervaluation in response to bad news. By optimally increasing its exposure to fundamental risks when the market price conveys good news, the firm shifts its dividend risk to the upside, which amplifies the overvaluation and explains the premium. Second, we argue that explicitly linking managerial compensation to share prices gives managers an incentive to manipulate the firm's decisions to their own benefit. The managers take advantage of shareholders by taking excessive investment risks when the market is optimistic, and investing too little when the market is pessimistic. The amplified upside exposure is rewarded by the market through a higher share price, but is inefficient from the perspective of dividend value.

Suggested Citation

Albagli, Elias and Hellwig, Christian and Tsyvinski, Aleh, Information Aggregation, Investment, and Managerial Incentives (August 10, 2011). Cowles Foundation Discussion Paper No. 1816. Available at SSRN: https://ssrn.com/abstract=1909809 or http://dx.doi.org/10.2139/ssrn.1909809

Elias Albagli

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA 90089
United States
56987096932 (Phone)

HOME PAGE: http://www.marshall.usc.edu/faculty/directory/albagli

Central Bank of Chile ( email )

Publicaciones
Huerfanos 1185
Santiago
Chile

Christian Hellwig

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

Aleh Tsyvinski (Contact Author)

Yale University - Cowles Foundation ( email )

28 Hillhouse Ave
New Haven, CT 06520-8268
United States
203-432-9163 (Phone)

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