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Information Aggregation, Investment, and Managerial Incentives

  • Albagli, Elias
  • Hellwig, Christian
  • Tsyvinski, Aleh

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 C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8539.

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Date of creation: Aug 2011
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Handle: RePEc:cpr:ceprdp:8539
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  1. George-Marios Angeletos & Guido Lorenzoni & Alessandro Pavan, 2010. "Beauty Contests and Irrational Exuberance: A Neoclassical Approach," NBER Working Papers 15883, National Bureau of Economic Research, Inc.
  2. Rohit Rahi & James Dow, 1998. "Informed Trading, Investment, and Welfare," FMG Discussion Papers dp292, Financial Markets Group.
  3. Stein, Jeremy C, 1988. "Takeover Threats and Managerial Myopia," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 61-80, February.
  4. Itay Goldstein & Alexander Guembel & James Dow, 2008. "Incentives for Information Production in Markets where Prices Affect Real Investment," 2008 Meeting Papers 270, Society for Economic Dynamics.
  5. Aleh Tsyvinski & Arijit Mukherji & Christian Hellwig, 2006. "Self-Fulfilling Currency Crises: The Role of Interest Rates," American Economic Review, American Economic Association, vol. 96(5), pages 1769-1787, December.
  6. Goldstein, Itay & Ozdenoren, Emre & Yuan, Kathy, 2010. "Trading Frenzies and Their Impact on Real Investment," CEPR Discussion Papers 7652, C.E.P.R. Discussion Papers.
  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. repec:bla:restud:v:75:y:2008:i:1:p:133-164 is not listed on IDEAS
  9. 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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