Risk Sharing, Investment Efficiency, and Welfare with Feedback Effects

Abstract

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