DP9917 Feedback Effects and the Limits to Arbitrage
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 buying on good news, it reduces the profitability of selling on bad news. 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.