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Information Aggregation, Investment, and Managerial Incentives

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  • Elias Albagli
  • Christian Hellwig
  • Aleh Tsyvinski

Abstract

We study the interplay of share prices and firm decisions when share prices aggregate and convey noisy information about fundamentals to investors and managers. First, we show that the informational feedback between the firm's share price and its investment decisions leads to a systematic premium in the firm's share price relative to expected dividends. Noisy information aggregation leads to excess price volatility, over-valuation of shares in response to good news, and undervaluation in response to bad news. By optimally increasing its exposure to fundamental risks when the market price conveys good news, the firm shifts its dividend risk to the upside, which amplifies the overvaluation and explains the premium. Second, we argue that explicitly linking managerial compensation to share prices gives managers an incentive to manipulate the firm's decisions to their own benefit. The managers take advantage of shareholders by taking excessive investment risks when the market is optimistic, and investing too little when the market is pessimistic. The amplified upside exposure is rewarded by the market through a higher share price, but is inefficient from the perspective of dividend value.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17330.

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Date of creation: Aug 2011
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Handle: RePEc:nbr:nberwo:17330

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  1. Stein, Jeremy C., 1988. "Takeover Threats and Managerial Myopia," Scholarly Articles 3708937, Harvard University Department of Economics.
  2. Christian Hellwig & Arijit Mukherji & Aleh Tsyvinski, 2005. "Self-Fulfilling Currency Crises: The Role of Interest Rates," NBER Working Papers 11191, National Bureau of Economic Research, Inc.
  3. Kathy Yuan & Emre Ozdenoren & Itay Goldstein, 2010. "Trading Frenzies and Their Impact on Real Investment," 2010 Meeting Papers 94, Society for Economic Dynamics.
  4. Dow, J & Rahi, R, 1997. "Informed Trading, Investment, and Welfare," Economics Working Papers eco97/03, European University Institute.
  5. George-Marios Angeletos & Guido Lorenzoni & Alessandro Pavan, 2010. "Beauty Contests and Irrational Exuberance: A Neoclassical Approach," Levine's Working Paper Archive 661465000000000237, David K. Levine.
  6. Itay Goldstein & Alexander Guembel, 2008. "Manipulation and the Allocational Role of Prices," Review of Economic Studies, Wiley Blackwell, vol. 75(1), pages 133-164, 01.
  7. Christopher Polk & Paola Sapienza, 2009. "The Stock Market and Corporate Investment: A Test of Catering Theory," Review of Financial Studies, Society for Financial Studies, vol. 22(1), pages 187-217, January.
  8. Itay Goldstein & Alexander Guembel, 2008. "Manipulation and the Allocational Role of Prices," Review of Economic Studies, Oxford University Press, vol. 75(1), pages 133-164.
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