Feedback Effects and the Limits to Arbitrage

52 Pages Posted: 15 Nov 2011

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

Wei Jiang

Columbia Business School - Finance and Economics

Multiple version iconThere are 3 versions of this paper

Date Written: November 2011

Abstract

This paper identifies a limit to arbitrage that arises from the fact that a firm's fundamental value is endogenous to the act of exploiting the arbitrage. Trading on private information reveals this information to managers and helps them improve their real decisions, in turn enhancing fundamental value. While this increases the profitability of a long position, it reduces the profitability of a short position -- selling on negative information reveals that firm prospects are poor, causing the manager to cancel investment. Optimal abandonment increases firm value and may cause the speculator to realize a loss on her initial sale. Thus, investors may strategically refrain from trading on negative information, and so bad news is incorporated more slowly into prices than good news. The effect has potentially important real consequences -- if negative information is not incorporated into stock prices, negative-NPV projects may not be abandoned, leading to overinvestment.

Suggested Citation

Edmans, Alex and Goldstein, Itay and Jiang, Wei, Feedback Effects and the Limits to Arbitrage (November 2011). NBER Working Paper No. w17582. Available at SSRN: https://ssrn.com/abstract=1959769

Alex Edmans (Contact Author)

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

Sussex Place
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London NW1 4SA
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European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
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Belgium

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Itay Goldstein

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

The Wharton School
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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)

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