Feedback Effects and the Limits to Arbitrage

When:
March 23, 2012 @ 2:00 pm – 3:30 pm America/New York Timezone
2012-03-23T14:00:00-04:00
2012-03-23T15:30:00-04:00
Where:
CEAR
Georgia State University
35 Broad Street Northwest, Atlanta, GA 30303
USA
Cost:
Free
Contact:
CEAR

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Motivation: 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 over investment.