Working Paper: NBER ID: w17582
Authors: Alex Edmans; Itay Goldstein; Wei Jiang
Abstract: 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.
Keywords: arbitrage; market efficiency; feedback effects
JEL Codes: G14; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| trading on private information (G14) | managerial decisions (M51) |
| managerial decisions (M51) | fundamental value of a firm (G32) |
| trading on private information (G14) | fundamental value of a firm (G32) |
| negative trading (F19) | managerial action (cancellation of investments) (G31) |
| managerial action (cancellation of investments) (G31) | fundamental value of a firm (G32) |
| fundamental value of a firm (G32) | profitability of short position (G13) |
| trading on positive information (G14) | managerial decisions (M51) |
| managerial decisions (M51) | profitability of long position (G13) |
| trading on positive information (G14) | fundamental value of a firm (G32) |
| asymmetry in trading behavior (G40) | incorporation of bad news into stock prices (G14) |