Feedback effects, asymmetric trading, and the limits to arbitrage

Edmans, A and Goldstein, I and Jiang, W (2015) Feedback effects, asymmetric trading, and the limits to arbitrage. American Economic Review (AER), 105 (12). pp. 3766-3797. ISSN 0002-8282

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We analyze strategic speculators' incentives to trade on information in a model where firm value is endogenous to trading, due to feedback from the financial market to corporate decisions. Trading reveals private information to managers and improves their real decisions, enhancing fundamental value. This feedback effect has an asymmetric effect on trading behavior: it increases (reduces) the profitability of buying (selling) on good (bad)news. This gives rise to an endogenous limit to arbitrage, whereby investors may refrain from trading on negative information. Thus, bad news is incorporated more slowly into prices than good news, potentially leading to overinvestment.

Item Type: Article
Additional Information: © 2015 American Economic Association. Permission to make digital or hard copies of part or all of American Economic Association publications for personal or classroom use is granted without fee provided that copies are not distributed for profit or direct commercial advantage
Subjects: F > Financial markets
P > Portfolio investment
S > Speculation
M > Mathematical models
Subject Areas: Finance
DOI: 10.1257/aer.20141271
Date Deposited: 17 May 2016 17:54
Last Modified: 12 Dec 2016 17:05

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