Feedback Effects and the Limits to Arbitrage

44 Pages Posted: 2 Jun 2014

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: March 2014

Abstract

This paper identifies a limit to arbitrage that arises because firm value is endogenous to the exploitation of arbitrage. Trading on private information reveals this information to managers and improves their real decisions, enhancing fundamental value. While this feedback effect increases the profitability of buying on good news, it reduces the profitability of selling on bad news. Thus, investors may refrain from trading on negative information, and so bad news is incorporated more slowly into prices than good news. This has potentially important real consequences -- if negative information is not incorporated into prices, inefficient projects are not canceled, leading to overinvestment.

Keywords: feedback effect, Limits to arbitrage, overinvestment

JEL Classification: G14, G34

Suggested Citation

Edmans, Alex and Goldstein, Itay and Jiang, Wei, Feedback Effects and the Limits to Arbitrage (March 2014). CEPR Discussion Paper No. DP9917. Available at SSRN: https://ssrn.com/abstract=2444860

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 )

London
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)

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