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Feedback Effects and the Limits to Arbitrage

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  • Goldstein, Itay
  • Edmans, Alex
  • Jiang, Wei

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.

Suggested Citation

  • Goldstein, Itay & Edmans, Alex & Jiang, Wei, 2014. "Feedback Effects and the Limits to Arbitrage," CEPR Discussion Papers 9917, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:9917
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    Cited by:

    1. Gary B. Gorton & Lixin Huang & Qiang Kang, 2017. "The Limitations of Stock Market Efficiency: Price Informativeness and CEO Turnover," Review of Finance, European Finance Association, vol. 21(1), pages 153-200.
    2. Dieler, T., 2014. "Essays on asset trading," Other publications TiSEM ea0c811e-e335-402f-a3e2-8, Tilburg University, School of Economics and Management.
    3. Pedraza Morales, Alvaro, 2014. "Strategic information revelation and capital allocation," Policy Research Working Paper Series 6995, The World Bank.
    4. Charlie X. Cai & Robert Faff & Yongcheol Shin, 2018. "Noise Momentum Around the World," Abacus, Accounting Foundation, University of Sydney, vol. 54(1), pages 79-104, March.
    5. Xuewen Liu, 2015. "Short-Selling Attacks and Creditor Runs," Management Science, INFORMS, vol. 61(4), pages 814-830, April.
    6. Axelson, Ulf & Makarov, Igor, 2016. "Informational black holes in financial markets," LSE Research Online Documents on Economics 118982, London School of Economics and Political Science, LSE Library.

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    More about this item

    Keywords

    Feedback effect; Limits to arbitrage; Overinvestment;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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