Working Paper: CEPR ID: DP7652
Authors: Itay Goldstein; Emre Ozdenoren; Kathy Yuan
Abstract: We study a model where a capital provider learns from the price of a firm?s security in deciding how much capital to provide for new investment. This feedback effect from the financial market to the investment decision gives rise to trading frenzies, where speculators all wish to trade like others, generating large shifts in prices and firms? investments. Coordination among speculators is sometimes desirable for price informativeness and investment efficiency, but speculators? incentives push in the opposite direction, so that they coordinate exactly when it is undesirable. We analyze the determinants of coordination among speculators and study policy measures that affect patterns of coordination to improve price informativeness and investment efficiency.
Keywords: Coordination; Financial Markets; Heterogeneous Information; Learning; Liquidity
JEL Codes: D82; G01; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| speculators coordinate trading (D84) | trading frenzies (E32) |
| trading frenzies (E32) | capital provider's decision on capital allocation (G31) |
| short selling by speculators (G13) | drives down stock price (G34) |
| driving down stock price (G19) | negatively signals capital provider (G24) |
| negatively signals capital provider (G24) | reduces amount of capital provided for investment (G31) |
| reducing amount of capital provided for investment (G31) | falling prices (E31) |
| falling prices (E31) | less investment (G31) |
| less investment (G31) | further drives down prices (D49) |
| liquidity in the market (G10) | incentives for speculators to coordinate trading decisions (D84) |
| illiquid markets (G19) | speculators coordinate more (D84) |
| illiquid markets (G19) | excessive price volatility and inefficiency in investment decisions (G19) |
| liquid markets (G10) | speculators coordinate less (D84) |
| sharper signals (C45) | more efficient investment decisions (G11) |