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Feedback Effects and the Limits to Arbitrage

Author

Listed:
  • Edmans, Alex

    (University of PA)

  • Goldstein, Itay

    (University of PA)

  • Jiang, Wei

    (University of PA)

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.

Suggested Citation

  • Edmans, Alex & Goldstein, Itay & Jiang, Wei, 2011. "Feedback Effects and the Limits to Arbitrage," Working Papers 11-67, University of Pennsylvania, Wharton School, Weiss Center.
    • Handle: RePEc:ecl:upafin:11-67
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    File URL: http://fic.wharton.upenn.edu/fic/papers/11/11-67.pdf
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    References listed on IDEAS

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    Cited by:

    1. Gary B. Gorton & Lixin Huang & Qiang Kang, 2017. "The Limitations of Stock Market Efficiency: Price Informativeness and CEO Turnover," Review of Finance, European Finance Association, vol. 21(1), pages 153-200.
    2. Dieler, T., 2014. "Essays on asset trading," Other publications TiSEM ea0c811e-e335-402f-a3e2-8, Tilburg University, School of Economics and Management.
    3. Pedraza Morales, Alvaro, 2014. "Strategic information revelation and capital allocation," Policy Research Working Paper Series 6995, The World Bank.
    4. Charlie X. Cai & Robert Faff & Yongcheol Shin, 2018. "Noise Momentum Around the World," Abacus, Accounting Foundation, University of Sydney, vol. 54(1), pages 79-104, March.
    5. Xuewen Liu, 2015. "Short-Selling Attacks and Creditor Runs," Management Science, INFORMS, vol. 61(4), pages 814-830, April.
    6. Axelson, Ulf & Makarov, Igor, 2016. "Informational black holes in financial markets," LSE Research Online Documents on Economics 118982, London School of Economics and Political Science, LSE Library.

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    More about this item

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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