Commitment to overinvest and price informativeness

Finance

IFA Working Paper

Dow J; Goldstein I; Guembel A

James Dow

2006

A fundamental role of financial markets is to gather information on firms' investment opportunities, and so help guide investment decisions in the real sector. In this paper we study the incentives for informaton production when prices perform this allocational role. We argue that firms' overinvestment is sometimes necessary to induce speculators in financial markets to produce information. If firms always cancel planned investments following poor stock market response, the value of their shares will become insensitive to information on investment opportuntieis, so that speculators will be deterred from producing information. We discuss several commitment devices firms can use to facilitate information production. We show that the mechanism studied in the paper amplifies shocks to fundamentals across stages of the business cycle.

Institute of Finance and Accounting

FIN 448

IFA Working Paper

No