Feedback Effects and the Limits to Arbitrage

Feedback Effects and the Limits to Arbitrage

Alex Edmans, Itay Goldstein, Wei Jiang

Series number :

Serial Number: 
318/2011

Date posted :

October 01 2011

Last revised :

November 19 2011
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Keywords

  • Limits to arbitrage • 
  • feedback effect • 
  • overinvestment

We analyze strategic speculators' incentives to trade on information in a model where firm value is endogenous to trading, due to feedback from the financial market to corporate decisions. Trading reveals private information to managers and improves their real decisions, enhancing fundamental value.

This feedback effect has an asymmetric effect on trading behavior: it increases (reduces) the profitability of buying (selling) on good (bad) news. This gives rise to an endogenous limit to arbitrage, whereby investors may refrain from trading on negative information. Thus, bad news is incorporated more slowly into prices than good news, potentially leading to overinvestment.

Published in

Published in: 
Publication Title: 
AMERICAN ECONOMIC REVIEW
Description: 
VOL. 105, NO. 12, DECEMBER 2015 (pp. 3766-97)

Authors

Real name: 
Itay Goldstein