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The Real Effects of Financial Markets

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  • Philip Bond
  • Alex Edmans
  • Itay Goldstein

Abstract

A large amount of activity in the financial sector occurs in secondary financial markets, where securities are traded among investors without capital flowing to firms. The stock market is the archetypal example, which in most developed economies captures a lot of attention and resources. Is the stock market just a side show or does it affect real economic activity? In this article, we discuss the potential real effects of financial markets that stem from the informational role of market prices. We review the theoretical literature and show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the price, and speculators’ trading behavior. We make two main points. First, we argue that a new definition of price efficiency is needed to account for the extent to which prices reflect information useful for the efficiency of real decisions (rather than the extent to which they forecast future cash flows). Second, incorporating the feedback effect into models of financial markets can explain various market phenomena that otherwise seem puzzling. Finally, we review empirical evidence on the real effects of secondary financial markets.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17719.

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Date of creation: Dec 2011
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Publication status: published as Philip Bond & Alex Edmans & Itay Goldstein, 2012. "The Real Effects of Financial Markets," Annual Review of Financial Economics, Annual Reviews, vol. 4(1), pages 339-360, October.
Handle: RePEc:nbr:nberwo:17719

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References

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  1. Simon Gilchrist & Charles P. Himmelberg & Gur Huberman, 2004. "Do Stock Price Bubbles Influence Corporate Investment?," NBER Working Papers, National Bureau of Economic Research, Inc 10537, National Bureau of Economic Research, Inc.
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  3. Fang, Vivian W. & Noe, Thomas H. & Tice, Sheri, 2009. "Stock market liquidity and firm value," Journal of Financial Economics, Elsevier, Elsevier, vol. 94(1), pages 150-169, October.
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  14. Khanna, Naveen & Slezak, Steve L & Bradley, Michael, 1994. "Insider Trading, Outside Search, and Resource Allocation: Why Firms and Society May Disagree on Insider Trading Restrictions," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 7(3), pages 575-608.
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  17. Fulghieri, Paolo & Lukin, Dmitry, 2001. "Information production, dilution costs, and optimal security design," Journal of Financial Economics, Elsevier, Elsevier, vol. 61(1), pages 3-42, July.
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Cited by:
  1. Oesch, David & Schuette, Dustin & Walter, Ingo, . "Real Effects of Investment Banking Relationships: Evidence from the Financial Crisis," Working Papers on Finance, University of St. Gallen, School of Finance 1405, University of St. Gallen, School of Finance.
  2. Weitzel, Utz & Kling, Gerhard, 2012. "Sold below value? Why some targets accept very low and even negative takeover premiums," MPRA Paper, University Library of Munich, Germany 42832, University Library of Munich, Germany.
  3. Foucault, Thierry & Fresard, Laurent, 2014. "Learning from peers' stock prices and corporate investment," Journal of Financial Economics, Elsevier, Elsevier, vol. 111(3), pages 554-577.
  4. Jennie Bai & Thomas Philippon & Alexi Savov, 2012. "Have financial markets become more informative?," Staff Reports, Federal Reserve Bank of New York 578, Federal Reserve Bank of New York.
  5. Gilberto Loureiro & Alvaro G. Taboada, 2013. "Do Improvements in the Information Environment Affect Real Investment Decisions?," NIPE Working Papers, NIPE - Universidade do Minho 20/2013, NIPE - Universidade do Minho.
  6. Gantchev, Nickolay, 2013. "The costs of shareholder activism: Evidence from a sequential decision model," Journal of Financial Economics, Elsevier, Elsevier, vol. 107(3), pages 610-631.
  7. Betton, Sandra & Eckbo, B. Espen & Thompson, Rex & Thorburn, Karin S., 2011. "Merger negotiations with stock market feedback," Discussion Papers, Department of Business and Management Science, Norwegian School of Economics 2011/8, Department of Business and Management Science, Norwegian School of Economics.

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