Feedback Effects and the Limits to Arbitrage
AbstractThis paper identifies a limit to arbitrage that arises from the fact that a firm's fundamental value is endogenous to the act of exploiting the arbitrage. Trading on private information reveals this information to managers and helps them improve their real decisions, in turn enhancing fundamental value. While this increases the profitability of a long position, it reduces the profitability of a short position -- selling on negative information reveals that firm prospects are poor, causing the manager to cancel investment. Optimal abandonment increases firm value and may cause the speculator to realize a loss on her initial sale. Thus, investors may strategically refrain from trading on negative information, and so bad news is incorporated more slowly into prices than good news. The effect has potentially important real consequences -- if negative information is not incorporated into stock prices, negative-NPV projects may not be abandoned, leading to overinvestment.
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Date of creation: Nov 2011
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Find related papers by JEL classification:
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
- G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-11-21 (All new papers)
- NEP-CTA-2011-11-21 (Contract Theory & Applications)
- NEP-PPM-2011-11-21 (Project, Program & Portfolio Management)
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