Risk Sharing, Investment Efficiency, and Welfare with Feedback Effects
52 Pages Posted: 20 Apr 2021 Last revised: 29 Jun 2021
Date Written: June 28, 2021
Financial markets enable risk sharing and efficient allocation of capital. We characterize how these roles interact in a “feedback effects” model with diversely informed, risk-averse investors and a manager who learns from prices when making an investment decision. While learning from prices always improves investment efficiency, we identify a novel channel by which it can reduce welfare. Namely, investment decisions change the stock’s exposure to underlying shocks and, consequently, investors’ ability to hedge risk. We show that this is a robust feature of general investment decisions, and outline implications for firm governance and policy.
Keywords: feedback effect, welfare, investment efficiency, hedging, market completeness
JEL Classification: D82, D84, G12, G14
Suggested Citation: Suggested Citation