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Feedback Effects and the Limits to Arbitrage

  • Alex Edmans
  • Itay Goldstein
  • Wei Jiang

This 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17582.

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Date of creation: Nov 2011
Date of revision:
Handle: RePEc:nbr:nberwo:17582
Note: AP CF
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