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American Economic Review Vol. 105 No. 12 2015

Feedback Effects, Asymmetric Trading, and the Limits to Arbitrage

Alex Edmans1; Itay Goldstein2; Wei Jiang3

1 London Business School, Regent’s Park, P-225, London NW1 4SA, UK, NBER, CEPR, and ECGI (e-mail: ) · 2 The Wharton School, 2321 Steinberg Hall–Dietrich Hall, 3620 Locust Walk, Philadelphia, PA 19104 (e-mail: ) · 3 Columbia Business School, 3022 Broadway, Uris Hall 803, New York, NY 10027 (e-mail: )

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Abstract

We analyze strategic speculators’ incentives to trade on information in a model where firm value is endogenous to trading, due to feedback from the financial market to corporate decisions. Trading reveals private information to managers and improves their real decisions, enhancing fundamental value. This feedback effect has an asymmetric effect on trading behavior: it increases (reduces) the profitability of buying (selling) on good (bad) news. This gives rise to an endogenous limit to arbitrage, whereby investors may refrain from trading on negative information. Thus, bad news is incorporated more slowly into prices than good news, potentially leading to overinvestment.

DOI
10.1257/aer.20141271
Volume
105
Issue
12
Pages
3766-3797
Language
en
Sources
openalex bibtex:phds-export.bib crossref

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