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Feedback effects, asymmetric trading, and the limits to arbitrage

Journal

American Economic Review

Subject

Finance

Publishing details

American Economic Review 2015 Vol 105:12 p 3766-3797

Authors / Editors

Edmans A;Goldstein I;Jiang W

Biographies

Alex Edmans

Publication Year

2015

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 a long position, it reduces the profitability of a short position. 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.

Publication Notes

Limits to arbitrage; Feedback effect; Overinvestment

Available on ECCH

No


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