Signaling, instrumentation, and CFO decision-making

Hennessy, C and Chemla, G (2022) Signaling, instrumentation, and CFO decision-making. Journal of Financial Economics, 144 (3). pp. 849-863. ISSN 0304-405X

Abstract

Building parable economies embedding econometricians, we view alternative estimators (Instrumental variables, fuzzy regression discontinuity, natural experiments, OLS, event studies) from the perspective of privately informed decision-makers, e.g., CFOs. Instrumental variable estimates can be misleading since randomization through observable instruments eliminates signal content arising from discretion. If the goal is informing discretionary decisions, rather than predicting outcomes after forced/mistaken actions, instrumentation is problematic, whereas OLS or event studies can be sufficient. The analysis shows that the utility of alternative estimators hinges upon often neglected assumptions about agent/econometrician information sets, as distinct from exclusion restrictions. We recommend parable economy estimation before real-world IV estimation.