Working Paper: CEPR ID: DP9917
Authors: Alex Edmans; Itay Goldstein; Wei Jiang
Abstract: This paper identifies a limit to arbitrage that arises because firm value is endogenous to the exploitation of arbitrage. Trading on private information reveals this information to managers and improves their real decisions, enhancing fundamental value. While this feedback effect increases the profitability of buying on good news, it reduces the profitability of selling on bad news. Thus, investors may refrain from trading on negative information, and so bad news is incorporated more slowly into prices than good news. This has potentially important real consequences -- if negative information is not incorporated into prices, inefficient projects are not canceled, leading to overinvestment.
Keywords: feedback effect; limits to arbitrage; overinvestment
JEL Codes: G14; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| arbitrage trading (G13) | managerial decisions (M51) |
| managerial decisions (M51) | fundamental value of the firm (G32) |
| trading on positive information (G14) | firm value (G32) |
| trading on positive information (G14) | managerial investment (G31) |
| negative information (D80) | reluctance to sell (R21) |
| reluctance to sell (R21) | slower incorporation of bad news into prices (G14) |
| good news (Y60) | rapid incorporation into prices (G19) |
| negative information (D80) | corrective managerial actions (M54) |
| corrective managerial actions (M54) | diminished potential profits (D25) |
| arbitrage trading (G13) | feedback effect (C92) |