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 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, and thus has an asymmetric effect on trading behavior. In particular, the feedback effect contributes to an endogenous limit to arbitrage, whereby 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.

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Citation

Edmans, Alex, Itay Goldstein, and Wei Jiang. "Feedback Effects, Asymmetric Trading, and the Limits to Arbitrage." American Economic Review 105, no. 12 (2015): 3766-3797.

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