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# Electronic copy available at: http://ssrn.

**com/abstract=1787732
**

Feedback E¤ects and the Limits to Arbitrage

+

Alex Edmans

Wharton, NBER, and ECGI

Itay Goldstein

Wharton

Wei Jiang

Columbia

October 27, 2011

Abstract

This paper identi…es a limit to arbitrage that arises from the fact that a …rm’s fundamental

value is endogenous to the act of exploiting the arbitrage. Trading on private information

reveals this information to managers and helps them improve their real decisions, in turn

enhancing fundamental value. While this increases the pro…tability of a long position, it

reduces the pro…tability of a short position – selling on negative information reveals that

…rm prospects are poor, causing the manager to cancel investment. Optimal abandonment

increases …rm value and may cause the speculator to realize a loss on her initial sale.

Thus, investors may strategically refrain from trading on negative information, and so bad

news is incorporated more slowly into prices than good news. The e¤ect has potentially

important real consequences – if negative information is not incorporated into stock prices,

negative-NPV projects may not be abandoned, leading to overinvestment.

Keywords: Limits to arbitrage, feedback e¤ect, overinvestment

JEL Classification: G14, G34

**aedmans@wharton.upenn.edu, itayg@wharton.upenn.edu, wj2006@columbia.edu. For helpful
**

comments, we thank Philip Bond, Mike Fishman, Kathleen Hanley, Dirk Jenter, Pete Kyle, Sam

Taylor, James Thompson, Dimitri Vayanos, Kostas Zachariadis, and seminar participants at the Fed-

eral Reserve Board, Wharton, the LSE Paul Woolley Centre Conference, and the Theory Conference

on Corporate Finance and Financial Markets. We thank Ali Aram, Guojun Chen, Chong Huang and

Edmund Lee for excellent research assistance. AE gratefully acknowledges …nancial support from

the Dorinda and Mark Winkelman Distinguished Scholar award and the Goldman Sachs Research

Fellowship from the Rodney L. White Center for Financial Research.

1

Electronic copy available at: http://ssrn.com/abstract=1787732

1 Introduction

Whether …nancial markets are informationally e¢cient is one of the most hotly-contested de-

bates in …nance. Proponents of market e¢ciency argue that pro…t opportunities in the …nancial

market will lead speculators to trade in a way that eliminates any mispricing. For example, if

speculators have negative information about a stock, and this information is not re‡ected in

the price, they will …nd it pro…table to sell the stock. This will push down the price, caus-

ing it to re‡ect speculators’ information. However, a sizable literature identi…es various limits

to arbitrage, which may deter speculators from trading on their information. (This notion of

“arbitrage” is broader than the traditional textbook notion of risk-free arbitrage from trading

two identical securities. Here, we use “arbitrage” to refer to investors trading on their private

information.) For example, De Long, Shleifer, Summers, and Waldmann (1990) and Shleifer

and Vishny (1997) show that the slow convergence of price to fundamental value may render

arbitrage activities too risky. This in turn dissuades trading if the speculator has a short hori-

zon, which may in turn arise from informational asymmetries with her own investors. Other

explanations for limited arbitrage rely on market frictions such as short-sales constraints. All

of these mechanisms treat the …rm’s fundamental value as exogenous to the arbitrage process

and rely on market imperfections to explain why speculators will not drive the price towards

fundamental value. Thus, as …nancial markets develop, these limits to arbitrage may weaken.

In this paper, we identify a quite di¤erent limit to arbitrage, which does not rely on exoge-

nous forces but is instead generated endogenously as part of the arbitrage process. It stems from

the fact that the value of the asset being arbitraged is endogenous to the act of exploiting the ar-

bitrage. By trading, speculators cause prices to move, which in turn reveals information to real

decision makers, such as managers, board members, corporate raiders, and regulators. These

decision makers then take actions based on the information revealed in the price, and these

actions change the underlying asset value. This may make the initial trading less pro…table,

deterring it from occurring in the …rst place.

To …x ideas, consider the following example. Suppose that a …rm (acquirer) announces the

acquisition of a target. Also assume that some speculators conducted some analysis suggesting

that this acquisition will be value-destructive. Traditional theory suggests that these speculators

should sell the acquirer’s stock. However, large-scale selling will convey to the acquirer that

speculators believe the acquisition is a bad idea. As a result, the acquirer may end up cancelling

the acquisition. In turn, cancellation of a bad acquisition will boost …rm value, reducing the

speculator’s pro…t from her short position and in some cases causing her to su¤er a loss. Put

di¤erently, the acquirer’s decision to cancel the acquisition means that the negative information

possessed by speculators is now less relevant, and hence they should not trade on it. Thus, the

information ends up not being re‡ected in the price.

Our mechanism is based on the presence of a feedback e¤ect from the …nancial market

to real economic decisions – that real decision makers learn from the market when deciding

their actions. A common perception is that managers know more about their own …rms than

2

outsiders (e.g. Myers and Majluf (1984)). While this is likely plausible for internal information

about the …rm in isolation, optimal managerial decisions also depend on external information

(such as market demand for a …rm’s products, or potential synergies with a target) about which

outsiders may be more informed. A classic example of how information from the stock market

can shape real decisions is Coca-Cola’s attempted acquisition of Quaker Oats. On November

20, 2000, the Wall Street Journal reported that Coca-Cola was in talks to acquire Quaker

Oats. Shortly thereafter, Coca-Cola con…rmed such discussions. The market reacted negatively,

sending Coca-Cola’s shares down 8% on November 20th and 2% on November 21st. Coca-Cola’s

board rejected the acquisition later on November 21st, potentially due to the negative market

reaction. The following day, Coca-Cola’s shares rebounded 8%. Thus, speculators who had

short-sold on the initial merger announcement, based on the belief that the acquisition would

destroy value, lost money – precisely the e¤ect modeled by this paper. In the same context,

Luo (2005) provides large-sample evidence that acquisitions are more likely to be cancelled if

the market reacts negatively to them, and that the e¤ect is more pronounced when the acquirer

is more likely to have something to learn from the market, e.g., for non-high-tech deals and

where the bidder is small. Relatedly, Edmans, Goldstein, and Jiang (2011) demonstrate that

a …rm’s market price a¤ects the likelihood that it becomes a takeover target, which may arise

because potential acquirers learn from the market price. More broadly, Chen, Goldstein, and

Jiang (2007) show that the sensitivity of investment to price is higher when the price contains

more private information not known to managers.

Moreover, our model can apply to corrective actions (i.e., actions that improve …rm value

upon learning negative information about …rm prospects) undertaken by stakeholders other

than the manager. Such stakeholders likely have less information than the manager and may

be more reliant on information held by outsiders. Examples include managerial replacement

(undertaken by the board, or by shareholders who lobby the board), a disciplinary takeover

(undertaken by an acquirer), or the granting of a subsidy or a bail-out (undertaken by the

government). We demonstrate a barrier to the feedback e¤ect, that hinders decision makers

from learning from the market.

An important aspect of our theory is that it generates asymmetry between trading on

positive and negative information. The feedback e¤ect delivers an equilibrium where speculators

trade on good news but do not trade on bad news. Yet, it does not give rise to the opposite

equilibrium, where speculators trade on bad news only. The intuition is as follows. When

speculators trade on information, they improve the e¢ciency of the …rm’s decisions – regardless

of the direction of their trade. If the speculator has positive information on a …rm’s prospects,

trading on it will reveal to the manager that investment is pro…table. This will in turn cause

the …rm to invest more, thus increasing its value. If the speculator has negative information,

trading on it will reveal to the manager that investment is unpro…table. This will in turn cause

the …rm to invest less, also increasing its value as contraction is the correct decision. When a

speculator buys and takes a long position in a …rm, she bene…ts further from increasing its value

3

via the feedback e¤ect. By contrast, when she sells and takes a short position, she loses from

increasing the …rm’s value via the feedback e¤ect. Note that, for the speculator to lose from

the feedback e¤ect, she must end up with a short position. If she ends with a long position, the

value of the shares she still holds onto are enhanced by the feedback e¤ect. Thus, the model

implies that investors are less likely to engage in short-sales than sales – even though the model

contains no short-sale constraints.

Even though the speculator’s trading behavior is asymmetric, in general it is not automatic

that the impact on prices is asymmetric. The market maker is fully rational and takes into

account the fact that the speculator buys on positive information and does not trade on negative

information. Thus, he adjusts his pricing function accordingly. Therefore, it may seem that

negative information will be impounded in prices to the same degree as positive information

– even though it may lead to a neutral rather than negative order ‡ow, the market maker

knows that a neutral order ‡ow can stem from the speculator having negative information but

choosing not to trade, and may decrease the price accordingly. By contrast, we show that

the asymmetry in trading behavior does translate into asymmetry in price impact. The crux is

that the market maker cannot distinguish the case of a speculator who has negative information

but chooses to withhold it, from the case in which the speculator is absent (i.e. there is no

information). Thus, a neutral order ‡ow does not lead to a large stock price decrease, and so

negative information has a smaller e¤ect on prices. Indeed, Hong, Lim, and Stein (2000) show

empirically that bad news is incorporated in prices more slowly than good news. They speculate

that this arises because it is …rm management that possesses value-relevant information, and

they will publicize it more enthusiastically for favorable than unfavorable information. Our

paper presents a formal model that o¤ers an alternative explanation. Here, key information is

held by a …rm’s investors rather than its managers, who “publicize” it not through public news

releases, but by trading on it. They also choose to disseminate good news more readily than

bad news, but for a very di¤erent reason from …rm management, i.e., because of the feedback

e¤ect.

In standard models of underreaction, if bad news has a smaller e¤ect on short-run returns

(i.e. between t = 0 and t = 1) than good news, this must be counterbalanced by bad news

generating a larger long-run drift (between t = 1 and t = 2) than good news. We show that

this need not be the case in a model with feedback. It is indeed true that, if the state is bad

and little bad news comes out in the short-run (due to the speculator not trading on it), there

is more bad news still to come out in the long-run. However, in a feedback model where …rm

value is endogenous, the manager can take a corrective action to mitigate the negative impact

of the state on …rm value. If the feedback e¤ect is su¢ciently strong, bad news has a smaller

e¤ect than good news in both the short-run and the long-run.

While the above considers the returns to good and bad news, the model also generates

predictions regarding the returns to good and bad investment decisions. Naturally, the returns

to investment are positive (both in the short-run and long-run) if the state is good and negative

4

if the state is bad. More interestingly, we show that the returns to good investment are more

front-loaded than the returns to a bad investment – i.e., a higher proportion of the returns

manifests at t = 1 than at t = 2. This result again stems from the asymmetry of the speculator’s

trading strategy. Even if the speculator is aware that the investment is bad at t = 1, she may

not trade on this information due to the feedback e¤ect. Thus, the value-destructiveness of

the investment seeps out ex post at t = 2. Thus, our model provides an explanation for the

negative long-run returns to M&A, documented by Agrawal, Ja¤e, and Mandelker (1992) and

Rau and Vermaelen (1998).

In addition to its interesting e¤ects on stock returns, the asymmetry of the speculator’s

trading strategy can also generate important real consequences. Since negative information is

not incorporated into prices, it does not in‡uence management decisions. Thus, while positive-

NPV projects will be encouraged, some negative-NPV projects will not be canceled – even

though there is an agent in the economy who knows with certainty that the project is negative-

NPV – leading to overinvestment overall. In contrast to standard overinvestment theories based

on the manager’s private bene…ts (e.g., Jensen (1986), Stulz (1990), Zwiebel (1996)), here the

manager is fully aligned with …rm value and there are no agency problems. The manager wishes

to maximize …rm value by learning from prices, but is unable to do so since speculators refrain

from revealing their information. Applied to M&A as well as organic investment, the theory

may explain why M&A appears to be “excessive” and a large fraction of acquisitions destroy

value (see, e.g., Andrade, Mitchell, and Sta¤ord (2001).)

As mentioned above, the primary motivation for our paper is to identify a limit to arbitrage.

Di¤erent authors have emphasized di¤erent factors that lead to limits on arbitrage activities.

Campbell and Kyle (1993) focus on fundamental risk, i.e., the risk that …rm fundamentals will

change while the arbitrage strategy is being pursued. In their model, such changes are unrelated

to speculators’ arbitrage activities. De Long, Shleifer, Summers, and Waldmann (1990) argue

that noise-trading risk, i.e., the risk that noise trading will increase the degree of mispricing,

may render arbitrage activities unpro…table. Noise trading only a¤ects the asset’s market price

and not its fundamental value, which is again exogenous to the act of arbitrage. Shleifer and

Vishny (1997) show that, even if an arbitrage strategy is sure to converge in the long-run, the

possibility that mispricing may widen in the short-term may deter speculators from trading on

it, if they are concerned with redemptions by their own investors. Similarly, Kondor (2009)

demonstrates that …nancially-constrained arbitrageurs may stay out of a trade if they believe

that it may become more pro…table in the future. Many authors (e.g., Ponti¤ (1996), Mitchell

and Pulvino (2001), and Mitchell, Pulvino, and Sta¤ord (2002)) focus on the transaction costs

and holding costs that arbitrageurs have to incur while pursuing an arbitrage strategy. Others

(Geczy, Musto, and Reed (2002), and Lamont and Thaler (2003)) discuss the importance of

short-sales constraints. While these papers emphasize market frictions as the source of limits to

arbitrage, our paper shows that limits to arbitrage arise when the market performs its utmost

e¢cient role: guiding the allocation of real resources. Thus, while limits to arbitrage based

5

on market frictions tend to attenuate with the development of …nancial markets, the e¤ect

identi…ed by this paper may strengthen – as investors become more sophisticated, managers

will learn from them to a greater degree. Our model deliberately shuts down the sources of the

limits to arbitrage identi…ed by prior theories: the speculator is risk-neutral, there are no agency

problems due to portfolio delegation, and there is no exogenous friction on trading (other than

a standard transaction cost), such as short-sale constraints. With all these forces switched o¤, a

limit to arbitrage nevertheless arises because the speculator endogenously chooses not to trade

due to the feedback e¤ect.

Our paper is related to the literature exploring the theoretical implications of the feedback

e¤ects from market prices to real decision making. Several papers in this literature have shown

that the feedback e¤ect can be harmful for real e¢ciency. Most closely related is Goldstein and

Guembel (2008), who show that it provides an incentive for uninformed speculators to short sell

a stock, reducing its value by inducing a real decision (investment) based on false information.

Their paper also highlights an asymmetry between buy-side and sell-side speculation, but only

with respect to uninformed trading; here, we show that informed speculators are less likely

to trade on bad news rather than good news, in turn generating implications for the speed of

incorporation of news into prices.

1

Bond, Goldstein, and Prescott (2010), Dow, Goldstein, and

Guembel (2010), and Goldstein, Ozdenoren, and Yuan (2011) also model complexities arising

from the feedback e¤ect. Overall, the point in our paper – that negatively informed speculators

will strategically withhold information from the market, because they know that the release of

negative information will lead managers to …x the underlying problem – is new in this literature.

This paper proceeds as follows. Section 2 presents the model. Section 3 contains the core

analysis, demonstrating the asymmetric limit to arbitrage. Section 4 investigates the extent to

which information a¤ects beliefs and prices, Section 5 discusses potential applications of the

model, and Section 6 concludes. Appendix A contains all proofs not in the main text.

2 The Model

The model has three dates, t ¸ ¦0. 1. 2¦. There is a …rm whose stock is traded in the …nancial

market. The …rm’s manager needs to take a decision as to whether to continue or abandon an

investment project. The manager’s goal is to maximize expected …rm value; since there are no

agency problems between the manager and the …rm, we will use these two terms interchangeably.

At t = 0, a risk-neutral speculator may be present in the …nancial market. If present, she

is informed about the state of nature o that determines the pro…tability of continuing vs.

abandoning the project. Trading in the …nancial market occurs at t = 1. In addition to the

speculator, two other types of agents participate in the …nancial market: noise traders whose

trades are unrelated to the realization of o, and a risk-neutral market maker. The latter collects

1

In addition, while they require two trading periods to generate the asymmetry, our model is simpler and

requires only a single period.

6

the orders from the speculator and noise traders, and sets a price at which he executes the orders

out of his inventory. At t = 2, the manager takes the decision, which may be a¤ected by the

trading in the …nancial market at t = 1. Finally, all uncertainty is resolved and payo¤s are

realized. We now describe the …rm’s investment problem and the trading process in more detail.

2.1 The Firm’s Decision

Suppose that the …rm has an investment project that can be either continued or abandoned

at t = 2. We denote the …rm’s decision as d ¸ ¦i. :¦, where d = i represents continuing

the investment and d = : represents no investment (also referred to as “abandonment” or

“correction”). The …rm faces uncertainty over the realization of value under each possible

action. In particular, there are two possible states o ¸ = ¦H. 1¦ (“high” and “low”). We

denote the value of the …rm realized in t = 2 as · = 1

d

**, which depends on both the state of
**

nature o and the manager’s action d.

We assume that whether continuation or abandonment is desirable depends on the state of

nature (i.e., there is no dominant action). Without loss of generality, we set:

1

i

H

1

n

H

(1)

1

n

L

1

i

L

. (2)

that is, continuation is optimal in state H, while abandonment is optimal in state 1. We also

set:

1

i

H

1

n

L

, (3)

that is, under the optimal action, the highest …rm value is achieved in state H, consistent with

this being labeled as the “high” state. This assumption is also without loss of generality as,

if it is not satis…ed, the highest …rm value is achieved in state 1 and we can simply reverse

notations.

Note that equations (1) and (2) imply:

1

i

H

÷1

i

L

1

n

H

÷1

n

L

. (4)

Equation (4) is the driving force behind our results. It means that taking the corrective action

reduces the negative e¤ect of state 1 on …rm value. Put di¤erently, if the state is 1 rather than

H, the reduction in …rm value is lower if the manager has taken action :. In turn, equation (4)

incorporates two cases, depending on whether …rm value is monotonic in the underlying state:

Case 1: 1

n

H

1

n

L

. In this case, state H is better for …rm value, no matter what action

has been taken by the …rm. Hence, the corrective action attenuates, but does not eliminate,

the e¤ect of the state on …rm value. Abandonment reduces the volatility of …rm value, i.e., the

dependence of …rm value on the state. For example, state H can represent high demand for the

…rm’s products, while state 1 represents low demand. Whether the …rm continues to invest in

7

its production process or not, its value will be lower in state 1, but the negative e¤ect of state

1 is attenuated if the …rm does not invest.

Case 2: 1

n

L

1

n

H

. In this case, if the corrective action is taken, …rm value is higher in state

1. Put di¤erently, the corrective action is su¢ciently powerful to overturn the e¤ect of the

state on …rm value. Importantly, this second case does not require that abandonment reduces

the volatility of …rm value: it could be that c/: (1

n

H

÷1

n

L

) c/: (1

i

H

÷1

i

L

) so volatility is

higher under correction. Instead, the case 1

n

L

1

n

H

implies non-monotonicity of …rm value

in the state: one state does not dominate the other. For example, consider the case where

continuation implies proceeding with a takeover decision, and abandonment implies keeping

the cash for future opportunities. State H corresponds to a state in which current acquisition

opportunities dominate future ones, and state 1 refers to the reverse. Under continuation, …rm

value is higher in state H, whereas if the …rm chooses to postpone acquisitions, its value is higher

in state 1 where future acquisition opportunities are superior. Another example is related to

Aghion and Stein (2008): d = i corresponds to a growth strategy, and d = : corresponds to

a strategy focused on current pro…t margins. Growth prospects are good if o = H and bad if

o = 1. If the …rm eschews the growth strategy (d = :), its value is higher in the low state

where there are no growth opportunities, since in the high state, its rivals could pursue the

growth opportunities, in turn worsening its competitive position.

The prior probability that the state is o = H is ¸ =

1

2

, which is common knowledge. We use

¡ to denote the posterior probability the manager assigns to the case o = H. The manager’s

decision is conditioned on ¡, which in turn is calculated using information arising from trades

in the …nancial market. Let ¸ denote the posterior belief that the state is H such that the

manager is indi¤erent between continuation and abandonment, i.e.:

¸1

i

H

+ (1 ÷¸)1

i

L

= ¸1

n

H

+ (1 ÷¸)1

n

L

. (5)

The value of ¸ represents a “cuto¤” that determines the manager’s action. If and only if ¡ ¸,

he will continue the project. We will distinguish between two cases. The …rst case is where

¸ <

1

2

. Since the prior ¸ is

1

2

, the manager would continue the investment without further

information, i.e., ex ante, the investment has a positive net present value. The second case is

where ¸

1

2

, and so the ex-ante net present value of the investment is negative.

2.2 Trade in the Financial Market

In t = 0, with probability 0 < ` < 1, a speculator arrives in the …nancial market. Whether the

speculator is present or not is unknown to anyone else.

2

If the speculator is present, she observes

the state of nature o with certainty. We will use the term “positively-informed speculator” to

2

Since private information is not public knowledge, its existence is also unlikely to be public knowledge.

Chakraborty and Yilmaz (2004) also feature uncertainty on whether the speculator is present, in an equilibrium

in which informed insiders manupulate the market by trading in the wrong direction.

8

describe a speculator who observes o = H, and “negatively-informed speculator” to describe a

speculator who observes o = 1. The variable ` is a measure of market sophistication or the

informedness of outside investors and will generate a number of comparative statics.

Trading in the …nancial market happens in t = 1. Always present is a noise trader, who

trades . = ÷1, 0, or 1 with equal probabilities. If the speculator is present, she makes an

endogenous trading choice : ¸ ¦÷1. 0. 1¦. Trading either ÷1 or 1 is costly for the speculator

and entails paying a cost of i. Unless otherwise speci…ed, we refer to trading pro…ts and losses

gross of the cost i. If the speculator is indi¤erent between trading and not trading (because

her expected pro…ts from trading exactly equal i), we assume that she will not trade.

Following Kyle (1985), orders are submitted simultaneously to a market maker who sets the

price and absorbs order ‡ows out of his inventory. The orders are market orders and are not

contingent on the price. The competitive market maker sets the price equal to expected asset

value, given the information contained in the order ‡ow. The market maker can only observe

total order ‡ow A = : +., but not its individual components : and .. Possible order ‡ows are

A ¸ ¦÷2. ÷1. 0. 1. 2¦ and the pricing function is j (A) = 1(·[A). A critical departure from

Kyle (1985) is that …rm value here is endogenous, because the manager’s action is based on

information revealed during the trading process.

Speci…cally, the manager observes total order ‡ow A, and uses the information in A to form

his posterior ¡, which is then used in the investment decision. Allowing the manager to observe

order ‡ow A, rather than just the price j, simpli…es the analysis without a¤ecting its economic

content. In the equilibria that we analyze, there is a one-to-one correspondence between the

price and the order ‡ow so it does not matter which variable the manager observes. Under the

alternative assumption that the manager observes j, other, non-interesting, equilibria can arise,

where the price is essentially uninformative. Since this paper’s focus is to analyze the feedback

e¤ect, which requires the price to be informative, we do not analyze such equilibria here. It

is also realistic to assume that managers have access to information about trading quantities

in the …nancial market: …rst, market making is competitive and so there is little secrecy in

the order ‡ow; second, microstructure databases (such as TAQ) provide such information at a

short lag – rapidly enough to guide investment decisions.

2.3 Equilibrium

The equilibrium concept we use is the Perfect Bayesian Nash Equilibrium. Here, it is de…ned

as follows: (i) A trading strategy by the speculator: o : ÷ ¦÷1. 0. 1¦ that maximizes his

expected …nal payo¤ :(· ÷j) ÷[:[i, given the price setting rule, the strategy of the manager,

and his information about the realization of o. (ii) An investment strategy by the …rm 1 :

Q ÷ ¦i. :¦ (where Q = ¦÷2. ÷1. 0. 1. 2¦), that maximizes expected …rm value · = 1

d

given

the information in the order ‡ow and all other strategies. (iii) A price setting strategy by the

market maker j : Q ÷ R that allows him to break even in expectation, given the information

in the price and all other strategies. Moreover, (iv) the …rm and the market maker use Bayes’

9

rule in order to update their beliefs from the order they observe in the …nancial market, and

(v) beliefs on outcomes not observed on the equilibrium path satisfy the Cho and Kreps (1987)

intuitive criterion. Finally, (vi) all agents have rational expectations in that each player’s belief

about the other players’ strategies is correct in equilibrium.

3 Feedback E¤ect and Asymmetric Limits to Arbitrage

In this section, we characterize the pure-strategy equilibria in our model. We demonstrate the

emergence of asymmetric limits to arbitrage as a result of the feedback from market trading

outcomes to the …rm’s investment decision. We consider Case 1 (1

n

H

1

n

L

) …rst and then

proceed to Case 2 (1

n

H

< 1

n

L

).

3.1 Case 1: Firm Value is Monotone in the State: 1

n

H

1

n

L

We start with the case where ¸ <

1

2

, i.e., without further information, the …rm will choose to

invest. Later, we will show that our main insight carries through to the case where ¸

1

2

. In

our characterization, we make use of three di¤erent threshold levels of the cost of trading i:

i

1

=

1

3

_

1

2

_

1

i

H

÷1

i

L

_

+

1 ÷`

2 ÷`

(1

n

H

÷1

n

L

)

_

. (6)

i

2

=

1

3

_

1

2

+

1 ÷`

2 ÷`

_

_

1

i

H

÷1

i

L

_

. (7)

i

3

=

1

3

_

1

i

H

÷1

i

L

_

, where (8)

i

1

< i

2

< i

3

. and (9)

i

2

÷i

1

=

1

3

1 ÷`

2 ÷`

__

1

i

H

÷1

i

L

_

÷(1

n

H

÷1

n

L

)

¸

0. (10)

The results also depend on whether order ‡ow is su¢ciently informative to overturn the decision

to invest, which is the ex-ante optimal decision. Hence, we distinguish between two cases

depending on whether the cuto¤ ¸ is higher or lower than

1

2

. As we will show, the quantity

1

2

is relevant as, in some equilibria, it represents the posterior probability of state H under

an order ‡ow of A = ÷1. The …rst case is

1

2

< ¸. Here, the probability ` that the speculator

is present is su¢ciently high that a negative order of A = ÷1 is su¢ciently informative to

deter the manager from investing. Thus, there is feedback from the market to real decisions for

the case of A = ÷1.

3

Second,

1

2

¸. Here, a negative order of A = ÷1 is not su¢ciently

informative to lead the manager to abandon the default plan of investing. Thus, there is no

feedback e¤ect for A = ÷1.

3

While X = ÷2 is also a negative order ‡ow, the …rm’s decision in this case is not relevant for equilibrium

trading strategies as the speculator’s information is fully revealed and so she never makes a pro…t. Thus, this

node is not relevant for determining the equilibrium trading strategies.

10

As we show, depending on the values of i, four equilibrium outcomes can arise:

1. No Trade Equilibrium `1: the speculator does not trade,

2. Trade Equilibrium 1: the speculator buys when she knows that o = H and sells when

she knows that o = 1,

3. Partial Trade Equilibrium 1`o (Buy - Not Sell): the speculator buys when she knows

that o = H and does not trade when she knows that o = 1,

4. Partial Trade Equilibrium o`1 (Sell - Not Buy): the speculator does not trade when

she knows that o = H and sells when she knows that o = 1.

Proposition 1 provides the characterization of equilibrium outcomes.

Proposition 1 (Equilibrium, …rm value is monotone in the state, investment is ex-ante desir-

able). Suppose that 1

n

H

1

n

L

and ¸ <

1

2

. Then the trading game has the following pure-strategy

equilibria:

When i < i

1

, the only pure-strategy equilibrium is 1.

When i

1

_ i < i

2

: in the case of feedback (

1

2

< ¸), the only pure-strategy equilibrium is

1`o; in the case of no feedback (

1

2

¸), the only pure-strategy equilibrium is 1.

When i

2

_ i < i

3

, there are two pure-strategy equilibria: 1`o and o`1.

When i _ i

3

, the only pure-strategy equilibrium is `1.

That is, if and only if there is feedback (

1

2

< ¸), there is a strictly positive range of

parameter values (i

1

_ i < i

2

) for which the 1`o equilibrium exists but the o`1 equilibrium

does not exist. There is no range of parameter values for which the o`1 equilibrium exists but

the 1`o equilibrium does not exist.

Proof. Given that …rm value is always higher when o = H than when o = 1, it is straight-

forward to show that the speculator will never buy when she knows that o = 1 and will never

sell when she knows that o = H. Then, the only possible pure-strategy equilibria are `1, 1,

1`o, and o`1. Below, we identify the conditions under which each one of these equilibria

holds. If an order ‡ow of A = ÷2 (A = 2) is observed o¤ the equilibrium path, the beliefs

of the market maker and the manager are that the speculator knows that the state is 1 (H).

Given that speculators always lose if they trade against their information, this is the only belief

that is consistent with the intuitive criterion.

No Trade Equilibrium `1:

For a given order ‡ow A, the posterior ¡, the manager’s decision d and the price j are given

by the following table (see Appendix A for the full calculations):

A ÷2 ÷1 0 1 2

¡ 0

1

2

1

2

1

2

1

d : i i i i

j 1

n

L

1

2

1

i

H

+

1

2

1

i

L

1

2

1

i

H

+

1

2

1

i

L

1

2

1

i

H

+

1

2

1

i

L

1

i

H

11

As shown in Appendix A, the pro…t for the negatively-informed speculator from deviating

to selling is

1

3

(1

i

H

÷1

i

L

), and this is also the pro…t for the positively-informed speculator from

deviating to buying. Thus, this equilibrium holds if and only if i _ i

3

.

Partial Trade Equilibrium o`1:

For a given order ‡ow A, the posterior ¡, the manager’s decision d and the price j are given

by the following table:

A ÷2 ÷1 0 1 2

¡ 0

1

2

1

2

1

2

1

d : i i i i

j 1

n

L

1

2

1

i

H

+

1

2

1

i

L

1

2

1

i

H

+

1

2

1

i

L

1

2

1

i

H

+

1

2

1

i

L

1

i

H

Calculating the pro…t for the negatively-informed speculator from deviating to not trad-

ing and for the positively-informed speculator from deviating to buying, we can see that this

equilibrium holds if and only if i

2

_ i < i

3

.

Partial Trade Equilibrium 1`o:

For a given order ‡ow A, the posterior ¡, the manager’s decision d and the price j are given

by the following table:

A ÷2 ÷1 0 1 2

¡ 0

1

2

1

2

1

2

1

d :

_

: if

1

2

< ¸

i if

1

2

¸

i i i

j 1

n

L

_

1

2

1

n

H

+

1

2

1

n

L

if

1

2

< ¸

1

2

1

i

H

+

1

2

1

i

L

if

1

2

¸

1

2

1

i

H

+

1

2

1

i

L

1

2

1

i

H

+

1

2

1

i

L

1

i

H

Calculating the pro…t for the negatively-informed speculator from deviating to selling and

for the positively-informed speculator from deviating to not trading, we can see that this equi-

librium holds if and only if i

2

_ i < i

3

for the case of no feedback (

1

2

¸) and if and only

if i

1

_ i < i

3

for the case of feedback (

1

2

< ¸).

Trade Equilibrium 1:

For a given order ‡ow A, the posterior ¡, the manager’s decision d and the price j are given

by the following table:

A ÷2 ÷1 0 1 2

¡ 0

1

2

1

2

1

2

1

d :

_

: if

1

2

< ¸

i if

1

2

¸

i i i

j 1

n

L

_

1

2

1

n

H

+

1

2

1

n

L

if

1

2

< ¸

1

2

1

i

H

+

1

2

1

i

L

if

1

2

¸

1

2

1

i

H

+

1

2

1

i

L

1

2

1

i

H

+

1

2

1

i

L

1

i

H

12

Calculating the pro…t for the negatively-informed speculator from deviating to not trading

and for the positively-informed speculator from deviating to not trading, we can see that this

equilibrium holds if and only if i < i

2

for the case of no feedback (

1

2

¸) and if and only if

i < i

1

for the case of feedback (

1

2

< ¸).

Thus, there is a range of i for which the only equilibrium is 1`o if i

1

< i

2

and

1

2

< ¸.

From (4) and (10), i

1

< i

2

requires ` < 1. In turn,

1

2

< ¸ requires `

12

1

. Thus, there

exist values of ` that satisfy both of the above conditions if

12

1

< 1, which always holds.

Proposition 1 demonstrates the sources of limits to arbitrage in our model, one of which is

the feedback e¤ect that is the focus of our paper. To understand the various forces, we start

by describing the equilibrium outcomes in the case of no feedback, i.e., when

1

2

¸. Here,

an order ‡ow of A = ÷1 may convey (depending on the equilibrium) negative information, but

not su¢ciently negative to deter the manager from abandoning the default plan of investing.

In this case, there are three regions of the parameter i. When i < i

2

, the only pure-strategy

equilibrium is one where the speculator always trades on her information. When i

2

_ i < i

3

,

there are two pure strategy equilibria, exhibiting limited trade, one in which the speculator

buys on good news but does not trade on bad news, and one in which she sells on bad news

but does not trade on good news. When i _ i

3

, the only pure-strategy equilibrium entails no

trade at all by the speculator.

Two sources of limits to arbitrage are present in the no-feedback case, both of which are

common in the literature. The …rst source is the trading cost i. As i increases, we move

to equilibria where speculators trade less on their information. Clearly, when speculators are

subject to greater transaction costs, they have lower incentives to trade. The second source is the

price impact that speculators exert when they trade on their information. In the intermediate

region i

2

_ i < i

3

, there are equilibria where the speculator trades on one type of information

but not the other. There is symmetry in that both types of asymmetric equilibria are possible

in exactly the same range of parameters. To understand the intuition behind these asymmetric

equilibria, consider the 1`o equilibrium without feedback (the case of the o`1 equilibrium

is analogous). Given that the market maker believes that the speculator buys on good news,

a negative order ‡ow is very revealing that the speculator is negatively informed and the price

moves sharply to re‡ect this. Speci…cally, A = ÷1 is inconsistent with the speculator having

positive information, and so the speculator only receives

1

2

1

i

H

+

1

2

1

i

L

from selling. Thus, the

speculator makes little pro…t from selling on bad news; knowing this, she chooses not to trade

on bad news. Conversely, given that the market maker believes that the speculator does not sell

on bad news, a positive order ‡ow is consistent with the speculator being negatively informed:

A = 1 is consistent with the noise trader buying, and the speculator being negatively informed

and choosing not to trade. Thus, the market maker sets a relatively low price of

1

2

1

i

H

+

1

2

1

i

L

,

which allows the speculator to make high pro…ts by buying. Thus, the equilibriumis sustainable.

In sum, in both partial trade equilibria, the order ‡ow in the direction in which the speculator

does not trade becomes particularly informative, leading to larger price impact which reduces

13

the potential trading pro…ts. Thus, not trading in this direction is sustained in equilibrium.

This force is symmetric in the absence of feedback.

We now move to the case of feedback, i.e., when

1

2

< ¸. Here, an order ‡ow of A = ÷1

provides enough negative information for the manager to abandon the investment. Abandon-

ment is the optimal decision in state 1; thus, improving the manager’s decision reduces the

speculator’s pro…t in the node of A = ÷1 from

1

2

(1

i

H

÷1

i

L

) (in the case of no-feedback) to

only

1

2

(1

n

H

÷1

n

L

). This reduced pro…t a¤ects the speculator’s equilibrium trading strategy

and causes her not to sell on bad news if i

1

_ i. Our main result is that the feedback e¤ect

introduces an additional limit to arbitrage that is distinct from those identi…ed in prior litera-

ture – arbitrage is limited because the value of the asset being arbitraged is endogenous to the

act of arbitrage. Unlike trading costs and price impact, the limit to arbitrage arising from the

feedback e¤ect is asymmetric: it reduces the extent of selling on bad news but not the extent of

buying on good news. Indeed, the di¤erence between equilibrium outcomes in the two cases of

no-feedback and feedback is that in the range i

1

_ i < i

2

, the Trade Equilibrium 1 is replaced

with the Partial Trade Equilibrium 1`o. However, there is no range of parameters where the

o`1 equilibrium exists but the 1`o equilibrium does not exist.

The intuition behind the asymmetry of our e¤ect is as follows. In the case of feedback, when

the speculator sells on bad news, she may lead the manager to abandon a bad investment. By

that, she improves …rm value, since 1

n

L

1

i

L

. Since she is holding a short position, this

increase in …rm value reduces her pro…t. Hence, it deters the speculator from selling on bad

news. On the other hand, the feedback e¤ect does not deter the positively-informed speculator

from buying on good news. Buying on good news may reveal to the manager that the state

is good, which (weakly) causes him to increase investment; since investment is desirable in the

high state, this augments …rm value. The speculator will then pro…t from the increase in the

value of her long position, which will further increase her incentive to trade.

4

Overall, trading on her information in either direction – whether it is buying on positive

information or selling on negative information – conveys information to the manager. This

improves his decision making and thus fundamental …rm value. Increased …rm value augments

the pro…tability of a long position but reduces the pro…tability of a short position. Hence, the

feedback e¤ect leads to an asymmetric limit to arbitrage that deters selling on bad news but

not buying on good news. By contrast, the two limits to arbitrage studied in prior research

are symmetric. A high trading cost i leads to the `1 equilibrium where there is no trading

in either direction. Price impact leads to the two partial trade equilibria, 1`o and o`1, but

there is symmetry in that both equilibria are possible in exactly the same range of parameters.

In particular, without feedback (i.e., if ¸

1

2

), there is no value of i in which there is one

4

In the case discussed so far ( <

1

2

) the default option for the manager is to invest, and so positive news

from the market does not change his decision and does not a¤ect …rm value. Hence we state that buying on

good information causes the manager to weakly increase investment. As we will show later, if >

1

2

, buying on

good news causes the manager to strictly increase investment, in turn strictly improving …rm value. This e¤ect

is the driving force behind our results in the case of >

1

2

.

14

partial trade equilibrium but not the other.

The reason for why the feedback e¤ect reduces trading pro…ts is nuanced. Intuition may

suggest that the market maker’s pricing function can “undo” the feedback e¤ect: the market

maker is fully rational and takes into account the fact that the order ‡ow will a¤ect the man-

ager’s decision; since he is competitive, he sets a price that re‡ects this decision. Because the

price that the speculator receives from selling will always re‡ect the action taken by the manager

(be it continuation or investment), it may seem that the action does not matter. Such intuition

turns out to be incorrect. The key to our result is that the source of the speculator’s pro…ts is

not superior knowledge of the manager’s action (since the action is always perfectly predicted

by the market maker), but superior knowledge of the state. In turn, superior knowledge of the

state results from fact that ` < 1, i.e., the speculator is not always present. To see this, consider

the market maker’s inference from seeing A = ÷1 in the 1`o equilibrium. This order ‡ow is

consistent with either the speculator being absent (in which case the state may be H or 1), or

the speculator being present and negatively informed. If ` = 1, the …rst case is ruled out, and

so the market maker knows for certain that o = 1. Thus, the order ‡ow of A = ÷1 is fully

revealing: the market maker knows both that correction will occur, and that the state is 1, and

so sets price exactly equal to the fundamental value of 1

n

L

. Thus, the speculator makes zero

pro…t. Indeed, if ` = 1, then i

1

= i

2

and there is no range of parameter values in which there

is a 1`o equilibrium only. By contrast, if ` < 1, the market maker predicts the manager’s

action but does not know the state. Since A = ÷1 can be consistent with the speculator being

absent and the state being H, the market maker allows for the possibility that the state may

be H and sets a price of

1

2

1

d

H

+

1

2

1

d

L

. Because the speculator knows both the manager’s

action and the state is 1, she makes a pro…t of

1

2

_

1

d

H

÷1

d

L

_

, which in turn depends on the

decision d. The source of her pro…t is her superior information on the state; since the state has

a lower e¤ect on …rm value under correction, her pro…ts are lower in this case. Put di¤erently,

the manager’s action d (and thus the feedback e¤ect on the manager’s action) matters for the

speculator’s trading pro…ts, not because the speculator’s pro…ts stem from superior knowledge

of the manager’s action, but because the action a¤ects the value of the speculator’s superior

knowledge on the state.

We now wish to verify that the asymmetry between buy-side speculation and sell-side specu-

lation, driven by the feedback e¤ect, is not an artifact of the fact that investment is the default

decision, i.e. the case ¸ <

1

2

. The next proposition shows that when ¸

1

2

, i.e., when the

default decision is abandonment, our results are qualitatively similar: without feedback, 1`o

and o`1 equilibria occur over the same range of parameters, whereas with feedback, the 1`o

equilibrium occurs over a wider range than the o`1 equilibrium. In the case of ¸ <

1

2

, the

source of the limit to arbitrage was that the feedback e¤ect reduces the pro…tability of a short

position but does not a¤ect the pro…tability of a long position, since positive order ‡ow leads

to investment but the investment would be undertaken in the absence of further information

anyway. Here, the source is that the feedback e¤ect increases the pro…tability of a long position

15

but does not a¤ect the pro…tability of a short position, since abandonment would be undertaken

in the absence of further information anyway. In both cases (for both ¸ <

1

2

and ¸

1

2

), the

intuition is the same: the feedback e¤ect (weakly) increases the pro…tability of a long position

and (weakly) decreases the pro…tability of short position, as discussed above.

For this proposition, de…ne new threshold levels of the cost of trading i:

i

0

1

=

1

3

_

1

2

(1

n

H

÷1

n

L

) +

1 ÷`

2 ÷`

_

1

i

H

÷1

i

L

_

_

. (11)

i

0

2

=

1

3

_

1

2

+

1 ÷`

2 ÷`

_

(1

n

H

÷1

n

L

) . (12)

i

0

3

=

1

3

(1

n

H

÷1

n

L

) . c:d (13)

i

0

2

< i

0

3

. i

0

2

< i

0

1

(14)

The cuto¤ for feedback e¤ect to exist is also adjusted here. In some equilibria,

1

2

represents

the posterior probability of state H if A = 1. If

1

2

¸, the probability ` that the speculator is

present is su¢ciently high that an order ‡ow of A = 1 contains enough information to lead the

manager to invest (as opposed to the default option of abandoning). Hence, there is feedback.

If

1

2

< ¸, an order ‡ow of A = 1 is not informative enough to lead the manager to invest.

This is the case where there is no feedback.

The following proposition provides the characterization of equilibrium outcomes.

Proposition 2 (Equilibrium, …rm value is monotone in the state, investment is ex-ante unde-

sirable). Suppose that 1

n

H

1

n

L

and ¸

1

2

, then the trading game has the following pure-strategy

equilibria:

When i < i

0

2

, the only pure-strategy equilibrium is 1.

When i

0

2

_ i < i

0

3

: in the case of no feedback (

1

2

< ¸), there are two pure-strategy

equilibria, 1`o and o`1; in the case of feedback (

1

2

¸), the 1`o equilibrium always

exists, whereas the o`1 equilibrium exists only in the sub-range i

0

1

_ i < i

0

3

or does not exist

(if i

0

1

i

0

3

).

When i _ i

0

3

, the only pure-strategy equilibrium is `1.

That is, if and only if there is feedback (

1

2

¸), there is a range of parameter values for

which the 1`o equilibrium exists but the o`1 equilibrium does not exist. If i

0

1

i

0

3

, this

range is i

0

2

_ i < i

0

3

; if i

0

1

< i

0

3

, this range is i

0

2

_ i < i

0

1

. There is no range of parameter

values for which the o`1 equilibrium exists but the 1`o equilibrium does not exist.

Proof. The proof repeats similar steps to those in the proof of Proposition 1, and is thus

omitted for brevity.

In the case of ¸ <

1

2

, the role of the feedback e¤ect can be seen in the 1`o equilibrium:

it reduces the pro…ts that the negatively-informed speculator would earn by deviating and

selling, and so the 1`o equilibrium is sustainable over a wider range of parameters than the

16

o`1 equilibrium. Here, where ¸

1

2

, the feedback e¤ect impacts the o`1 equilibrium.

Since buying improves the …rm’s fundamental value, the feedback e¤ect increases the pro…t

that the positively-informed speculator would earn by deviating and buying, and so the o`1

equilibrium is sustainable over a narrower range of parameters than the 1`o equilibrium

(indeed, if i

0

1

i

0

3

, it is not sustainable at all). In both cases (for ¸ <

1

2

and ¸

1

2

), the end

result is the same: the feedback e¤ect increases the pro…ts from informed buying and reduces

the pro…ts from informed selling, leading to the 1`o equilibrium being sustainable over a

wider range of transactions costs than the o`1 equilibrium.

3.2 Case 2: Firm Value is Non-Monotone in the State: 1

n

H

< 1

n

L

In this subsection, we consider the case where, if the …rm does not invest, its value is higher

in state o = 1 (1

n

H

< 1

n

L

). Hence, the corrective action is su¢ciently powerful to outweigh

the e¤ect of the state on …rm value and lead to a higher value in the low state. We start by

characterizing equilibrium outcomes for the case where ¸ <

1

2

, i.e., without further information,

the …rm will choose to invest.

The analysis of equilibriumoutcomes becomes more complicated in the case of non-monotonicity.

In the previous subsection, where …rmvalue is monotone in the state, a positively-informed spec-

ulator always loses money by selling and a negatively-informed speculator always loses money

by buying, since …rm value is always higher in state H than in state 1. However, now that …rm

value may be higher in state 1, a positively-informed speculator may …nd it optimal to sell and

a negatively-informed speculator may …nd it optimal to buy. Hence, there are nine possible

pure-strategy equilibria (each type of speculator – positively-informed and negatively-informed

– may either buy, sell, or not trade). The following lemma simpli…es the equilibrium analysis,

moving us closer to the analysis conducted in the previous subsection.

Lemma 1 Suppose that 1

n

H

< 1

n

L

and ¸ <

1

2

, then:

(i) The trading game has no pure-strategy equilibrium where the speculator sells when she

knows that o = H.

(ii) The trading game has no pure-strategy equilibrium where the speculator buys when she

knows that o = 1.

Proof. (i) Suppose that the speculator sells when she knows that o = H, then A ¸ ¦÷2. ÷1. 0¦.

In each one of these nodes, posterior probability ¡ of state H is at least

1

2

(given that these

nodes are consistent with the action of the positively-informed speculator and may or may not be

consistent with the action of the negatively-informed speculator, depending on her equilibrium

action). Then, since ¸ <

1

2

, investment will occur, and so …rm value is 1

i

H

. The price, however,

will be between 1

i

L

and 1

i

H

, and so the speculator makes a loss from selling.

(ii) Suppose that the speculator buys when she knows that o = 1, then A ¸ ¦0. 1. 2¦.

Given that the positively-informed speculator does not sell, the posterior probability ¡ is

1

2

at

A ¸ ¦0. 1¦. Hence, since ¸ <

1

2

, investment will occur, and so …rm value is 1

i

L

. Since the price

17

is

1

2

1

i

H

+

1

2

1

i

L

, the speculator will lose money on these nodes. When A = 2, there are two

possibilities. If the positively-informed speculator buys in equilibrium, then the outcome is the

same as on the other nodes. If she does not trade in equilibrium, then the negatively-informed

speculator is revealed, buying a security worth 1

n

L

for a price of 1

n

L

. Thus, in expectation she

makes a loss, given she loses at A ¸ ¦0. 1¦.

Following the lemma, there are four possible pure-strategy equilibria, just as in the previous

subsection: `1, 1, o`1, and 1`o. However, the conditions for these equilibria to hold are

now tighter. The reason that the positively-informed speculator never sells in equilibrium is

that if the market maker and the manager believe that she sells, she cannot make a pro…t from

selling. However, she still might be tempted to deviate to selling in any of the four equilibria

mentioned above. When she sells, she potentially misleads the market maker and the manager

to think that the negatively-informed speculator is present, and so to abandon the investment.

Since abandonment is suboptimal if o = H, this decision reduces …rm value and causes the

speculator to make a pro…t on her short position. Hence, for any of the above four equilibria to

hold, an additional condition must be satis…ed to ensure that the positively-informed speculator

does not have an incentive to deviate to selling. Interestingly, the same issue does not arise with

the negatively-informed speculator, as she never has an incentive to deviate to buying. If she

does so, she misleads the market maker and the manager to think that the positively-informed

speculator is present, and so to (incorrectly) take the investment. Again, this reduces …rm

value, but because the speculator has a long position, this causes her to make a loss.

5

In analyzing deviations from the equilibrium, another issue that arises in this subsection is

the speci…cation of o¤-equilibrium beliefs. In Case 1, due to monotonicity, the only assumption

that satis…ed the intuitive criterion was that an o¤-equilibrium order ‡ow of A = 2 is due

to the positively-informed speculator (and so the posterior is ¡ = 1), while an o¤-equilibrium

order ‡ow of A = ÷2 is due to the negatively-informed speculator (and so the posterior is

¡ = 0). In this subsection, however, the intuitive criterion is not su¢cient to rule out other

o¤-equilibrium beliefs. We nevertheless retain this assumption regarding o¤-equilibrium beliefs,

which is reasonable given the possible equilibria in our model. Our results remain the same for

any other o¤-equilibrium beliefs that are monotone in the order ‡ow.

The following proposition provides the characterization of equilibrium outcomes.

Proposition 3 (Equilibrium, …rm value is non-monotone in the state, investment is ex-ante

desirable). Suppose that 1

n

H

< 1

n

L

and ¸ <

1

2

, and suppose that the belief of the market

maker and the manager is that an o¤-equilibrium order ‡ow of A = ÷2 (A = 2) is associated

with the presence of negatively-informed (positively-informed) speculator. Then, if

(

R

i

H

R

i

L

)

(

R

n

L

R

n

H

)

is

su¢ciently high, the characterization of equilibrium outcomes is identical to that in Proposition

1.

5

Goldstein and Guembel (2008) also derive conditions to ensure that the speculator does not deviate from

the equilibrium to trade against her information.

18

More speci…cally, the following additional conditions are required for the various equilibria

to hold:

Equilibrium `1 and o`1: i

1

3

(÷(1

i

H

÷1

i

L

) + (1

n

L

÷1

n

H

));

Equilibrium 1`o: in the case of feedback (

1

2

< ¸),

63

62

(

R

i

H

R

i

L

)

(

R

n

L

R

n

H

)

1; in the case of no

feedback (

1

2

¸),

83

42

(

R

i

H

R

i

L

)

(

R

n

L

R

n

H

)

1.

Equilibrium 1: in the case of feedback (

1

2

< ¸),

32

3

(

R

i

H

R

i

L

)

(

R

n

L

R

n

H

)

1; in the case of no

feedback (

1

2

¸), 2

(

R

i

H

R

i

L

)

(

R

n

L

R

n

H

)

1.

Proof. The calculations of the posterior ¡, the manager’s decision d and the price j for di¤erent

order ‡ows A in the various possible equilibria are identical to those provided in the proof of

Proposition 1. Hence, the conditions for the positively-informed speculator to choose between

buying and not trading and for the negatively-informed speculator to choose between selling

and not trading are identical to those derived in the proof of Proposition 1. Analyzing the

possible trading pro…ts for the negatively-informed speculator from deviating to buying in each

of the four possible equilibria, it is straightforward to see that she always loses from buying and

hence will never deviate. Appendix A calculates the possible trading pro…ts for the positively-

informed speculator from deviating to selling in each of the four possible equilibria, which yields

obtain the additional conditions stated in the body of the proposition. These conditions are

binding only when

(

R

i

H

R

i

L

)

(

R

n

L

R

n

H

)

is not su¢ciently high.

As the proposition demonstrates, the main force identi…ed in the previous subsection for the

case where 1

n

H

1

n

L

, exists also in the case where 1

n

H

< 1

n

L

. That is, the feedback e¤ect deters

the negatively-informed speculator, but not the positively-informed speculator, from trading on

her information. In this subsection, this force is even stronger because the range of transaction

costs i between i

1

and i

2

, in which the 1`o equilibrium exists due to feedback but the

o`1 equilibrium does not exist, is higher when (1

n

H

÷1

n

L

) is negative: see equation (10). A

strong feedback e¤ect, in which correction not only mitigates the e¤ect of the low state but

also overturns it, implies that the negatively-informed speculator can make a loss – even before

transaction costs – when selling on bad news. This result is in contrast to standard informed

trading models where a speculator can never make a loss (before transactions costs) if she trades

in the direction of her information. This loss occurs at the A = ÷1 node; again, the key to this

result is ` < 1. Even though both the speculator and market maker know that abandonment

will occur if A = ÷1, they have di¤ering views on …rm value conditional on abandonment.

The speculator knows that the corrective action will be taken, and that correction is desirable

for …rm value (since she knows that o = 1), and so …rm value is 1

n

L

. In contrast, the market

maker knows the corrective action will be taken but is not certain that correction is desirable

for …rm value, because she is unsure of the underlying state o. Order ‡ow A = ÷1 is consistent

with a negatively-informed speculator, but also with an absent speculator and selling by noise

traders. Hence, it is possible that o = H, in which case the manager’s corrective action is

19

undesirable, leading to …rm value of 1

n

H

. Therefore, the price set by the market maker is only

1

2

1

n

H

+

1

2

1

n

L

, since he puts weight on the fact that correction may be undesirable, and so

the speculator loses

1

2

(1

n

H

÷1

n

L

) before transaction costs.

However, the proposition also shows that another force that arises from the feedback e¤ect

exists in this subsection, and that this force has implications on the characterization of equi-

librium outcomes. This is the desire of the positively-informed speculator to deviate from her

equilibrium behavior and manipulate the price by selling, even though she has good news. She

can potentially pro…t from leading the manager to take the wrong decision, which enables her

to pro…t from her short position. The manipulation incentive is not strong enough to interfere

with equilibrium conditions as long as

(

R

i

H

R

i

L

)

(

R

n

L

R

n

H

)

is su¢ciently high. In this case, the loss from

trading against good news (which is proportional to (1

i

H

÷1

i

L

)) is high relative to the bene-

…t from manipulation (which is proportional to (1

n

L

÷1

n

H

)). Otherwise, there are additional

conditions for the various possible equilibria, making it relatively more di¢cult to obtain the

1`o equilibrium due to feedback.

Finally, we analyze the case where ¸

1

2

. It turns out that this case is the exact mirror

image of the case where ¸ <

1

2

. Now, e¤ectively, o = H represents bad news and o = 1

represents good news. This is because the default decision is to abandon the investment; under

this decision, …rm value is lower in state H than in state 1. Thus, the speculator now sells if

o = H and buys if o = 1. The next lemma is the mirror image of Lemma 1:

Lemma 2 Suppose that 1

n

H

< 1

n

L

and ¸

1

2

, then:

(i) The trading game has no pure-strategy equilibrium where the speculator sells when she

knows that o = 1.

(ii) The trading game has no pure-strategy equilibrium where the speculator buys when she

knows that o = H.

Proof. The proof is symmetric to the proof of Lemma 1 and hence is not repeated here.

Hence, the possible pure-strategy equilibria here are:

1. No Trade Equilibrium `1: the speculator does not trade,

2. Trade Equilibrium 1

0

: the speculator buys when she knows that o = 1 and sells when

she knows that o = H,

3. Partial Trade Equilibrium 1`o

0

(Buy - Not Sell): the speculator buys when she knows

that o = 1 and does not trade when she knows that o = H.

4. Partial Trade Equilibrium o`1

0

(Sell - Not Buy): the speculator does not trade when

she knows that o = 1 and sells when she knows that o = H.

The characterization of equilibrium outcomes in the following proposition is symmetric to

that in Proposition 3:

20

Proposition 4 (Equilibrium, …rm value is non-monotone in the state, investment is ex-ante

undesirable). Suppose that 1

n

H

< 1

n

L

and ¸

1

2

, and suppose that the belief of the market maker

and the manager is that an o¤-equilibrium order ‡ow of A = ÷2 (A = 2) is associated with the

positively-informed (negatively-informed) speculator. Then, the characterization of equilibrium

outcomes is symmetric to that in Proposition 3: parameters 1

i

H

, 1

i

L

, 1

n

H

, 1

n

L

are replaced with

parameters 1

n

L

, 1

n

H

, 1

i

L

, 1

i

H

, respectively, and equilibria 1, 1`o, o`1 are replaced with

equilibria 1

0

, 1`o

0

, o`1

0

, respectively.

Proof. The proof is symmetric to the proof of Proposition 3 and hence is not repeated here.

Overall, the result is identical to that of the case of ¸ <

1

2

. Due to feedback, the speculator

is deterred from selling when she has bad news, but not from buying when she has good news.

The only di¤erence is that now, bad news entails o = H and good news entails o = 1.

In Case 1 (1

n

H

1

n

L

), for the sub-case of ¸

1

2

, the role of the feedback e¤ect is seen

in the o`1 equilibrium: the feedback e¤ect increases the pro…ts that the positively-informed

speculator would earn by deviating to buying, and so the o`1 is sustainable over a narrower

range of parameters. In the current scenario of ¸

1

2

within Case 2 (1

n

H

< 1

n

L

), just as in the

scenario of ¸ <

1

2

(for both Case 1 and Case 2), the role of the feedback e¤ect is seen in the

1`o/1`o

0

equilibrium: it deters the speculator from deviating to sell on bad news (o = H

in this case).

3.3 Summary and Discussion of Assumptions

The above analysis has shown that the presence of feedback from market trading to …rms’

decisions creates a wedge between buy-side speculation and sell-side speculation, discouraging

speculators from selling on bad news, but encouraging them to buy on good news. Several

assumptions play a key role in generating this result. These assumptions in turn lead to

empirical predictions, since they demonstrate the conditions under which the asymmetric limit

to arbitrage will exist.

First, the trading in the market has to contain su¢cient information to in‡uence the man-

ager’s decision. For example, consider the result in Proposition 1: for the wedge to arise, we

require

1

2

< ¸. Hence, it is important that the probability ` that the speculator is present is

su¢ciently high so that the order ‡ow is su¢ciently informative to change managerial decisions.

In turn,

1

2

< ¸ is more likely to be satis…ed the closer ¸ is to

1

2

, i.e. the closer the NPV of the

project is to 0. When ¸ is close to

1

2

, the desirability of the investment is su¢ciently uncertain

that the manager’s decision will be in‡uenced by the trading in the …nancial market. If ¸ is very

low, the ex-ante NPV of the project is so high that the manager will almost always undertake

the investment, regardless of order ‡ow.

Second, another important assumption is that ` < 1, so there is uncertainty on whether there

is an informed speculator in the market. To see this, consider again the result in Proposition

21

1. The range between i

1

and i

2

, in which a 1`o equilibrium arises and a o`1 equilibrium

does not arise, shrinks to zero if ` = 1. This is because the di¤erence in expected pro…t from

buying on good information and selling on bad information stems entirely from the di¤erence

in pro…t in the node where the speculator is partially revealed (A = ÷1 or 1). If ` = 1, the

speculator is fully revealed in these nodes and her pro…ts are zero, leading to no asymmetry.

Where ` < 1, the speculator is not fully revealed and makes a positive pro…t from her private

information about the state; the value of this information depends on the manager’s decision

(as this a¤ects the dependence of …rm value on the state) and thus the feedback e¤ect. We

would achieve the same result by instead assuming that the speculator is always present and

informed, but can only trade with probability ` – for example, if with probability 1 ÷ ` she

receives a liquidity shock that prevents her from trading.

6

Third, the reason that the speculator loses from increasing the …rm’s value is that she ends

up with a short position. Hence, it is important that the speculator short sells rather than

just sells stocks she previously owned, which in turn requires the speculator’s initial position

to be zero (or, at least, less than the amount sold) and short-sales to be possible. Thus, the

model delivers the result that investors are more likely to engage in sales rather than short-

sales, even in the absence of a short-sales constraint. However, if the speculator maximizes

returns relative to other speculators or market indices rather than absolute returns (e.g. she is

a mutual fund benchmarked against the performance of other mutual funds), then our limit to

arbitrage may exist even if her initial position is strictly positive. For example, if she sells half

of her portfolio, she increases the value of the remaining half, but increases the value of the

entire portfolio held by her competitors, and so loses in relative terms. In this case, the limit

to arbitrage identi…ed by this paper may exist even in the presence of short-sales constraints.

While short-sales constraints do not deter selling to a non-negative …nal position, the feedback

e¤ect can deter such selling if the speculator maximizes relative performance. Therefore, our

model also predicts that investors who are evaluated according to absolute returns are more

likely to sell on negative information than those who are benchmarked to their peers. Indeed,

hedge funds appear to sell (not just short-sell) more readily than mutual funds.

7

Fourth, the real decision is a corrective action in that it improves …rm value in the low

state. This is a natural assumption if the decision maker is the …rm’s manager who attempts

to maximize …rm value via an investment decision; another potential application is to a board

of directors which chooses whether to …re an underperforming manager in the bad state. The

model does not apply to amplifying actions that worsen …rm value in the low state, i.e. violate

6

An alternative assumption would be that the speculator is always present, but sometimes she is unin-

formed. This, however, may introduce other complications, as the uninformed speculator may choose to trade

to manipulate the price and the …rm’s decision, as in Goldstein and Guembel (2008).

7

Note that the existence of benchmarking alone is typically insu¢cient to explain the reluctance of mutual

funds to deviate from their benchmark, since the gains from beating one’s benchmark (by deviating) equal the

losses from underperforming one’s benchmark. Thus, existing explanations typically rely on the asymmetry in

in the ‡ow-performance relation: the in‡ows from beating one’s benchmark are lower than the out‡ows from

underperforming one’s benchmark. Our explanation for benchmarked investors’ unwillingness to sell does not

require such asymmetry.

22

assumption (2). For example, capital providers may withdraw their investment in the low state,

reducing …rm value further (as in Goldstein, Ozdenoren, and Yuan (2011)), or customers or

employees could terminate their relationship with a troubled …rm (Subrahmanyam and Titman

(2001)). Then, our model will have di¤erent implications: the speculator will no longer be

reluctant to sell on bad news, since the information will reduce …rm value further, enabling her

to pro…t more on her short position.

4 E¤ect of Information on Beliefs and Prices

The previous section demonstrated that the feedback e¤ect gives rise to an equilibrium where

a speculator buys on good news and does not trade on bad news. In this section, we study

the implications coming out of this equilibrium. The analysis that follows focuses on the 1`o

equilibrium where investment is ex-ante desirable (¸ <

1

2

) and there is feedback (

1

2

< ¸), and

considers both Case 1 and Case 2 together. Section 4.1 calculates the e¤ect of good and bad

news on the state on the posterior beliefs ¡, in order to study the extent to which information

reaches the manager and a¤ects real decisions. Section 4.2 analyzes the impact of news on

prices to generate stock return predictions.

4.1 Beliefs

Since the manager uses the posterior belief ¡ to guide his investment decision, ¡ measures the

extent to which information reaches the manager and a¤ects his actions. In a world in which

no agent observed the state, or in which the manager did not learn from prices or order ‡ow,

the posterior ¡ would equal the prior ¸ =

1

2

. Conversely, in a world of perfect information

transmission, ¡ = 1 if o = H and ¡ = 0 if o = 1. Our model, where information is partially

revealed through prices, lies in between these two polar cases. The absolute distance between

¡ and

1

2

measures the extent to which information reaches the manager.

Thus far, we have shown that good news received by the speculator has a di¤erent impact

on her trades (and thus total order ‡ow) than bad news. However, it is not obvious that

this will translate into a di¤erential impact on the manager’s beliefs. The manager is rational

and takes into account the fact that the speculator does not sell on negative information: he

updates his beliefs using the asymmetric equilibrium trading strategy. In the 1`o equilibrium

in the proof of Proposition 1, the manager recognizes that A = 1 could be consistent with a

negatively-informed speculator who chooses not to trade, and so ¡ (1) is no higher than ¡ (0)

(where ¡ (A) denotes the posterior at t = 1 upon observing order ‡ow A). Thus, even though

bad news can lead to a positive order ‡ow of A = 1, the manager knows that such an order ‡ow

can stem from a negatively-informed and non-trading speculator, and will decrease his posterior

accordingly. Put di¤erently, although negative information does not cause a negative order ‡ow

(on average), it can still have a negative e¤ect on beliefs and be fully conveyed to the manager.

23

Thus, it may seem still possible for good and bad news to be conveyed symmetrically to the

manager – by taking into account the speculator’s asymmetric trading strategy, he can “undo”

the asymmetry. Indeed, we start by showing that, if we do not condition on the presence of the

speculator, the e¤ects on beliefs of the high and low states being realized are symmetric. This

is a direct consequence of the law of iterated expectations: the expected posterior belief must

be equal to the prior.

Lemma 3 Consider the 1`o equilibrium where ¸ <

1

2

and

1

2

< ¸ (i.e., there is feedback).

(i) If o = H, the manager’s expected posterior probability of the high state is ¡

H

=

(1)

2

63

+

1

3

+

3

and is increasing in `. (ii) If o = 1, the manager’s expected posterior probability of the high

state is ¡

L

=

1

63

+

1

3

and is decreasing in `. (iii) We have

q

H

+q

L

2

=

1

2

: thus, the realization of

state H has the same absolute impact on beliefs as the realization of state 1.

Proof. See Appendix A.

Of greater interest is to study the e¤ect of the state realization conditional upon the spec-

ulator being present. We use the term “good news” to refer to o = H being realized and the

speculator being present, since in this case there is an agent in the economy who directly re-

ceives news on the state; “bad news” is de…ned analogously. While the above analysis studied

the e¤ect of the state being realized (regardless of whether the state is learned by any agent

in the economy), this analysis studies the impact of the speculator receiving information about

the state. The goal is to investigate the extent to which the speculator’s good and bad news is

conveyed to the manager at t = 1. The results are given in Proposition 5 below:

Proposition 5 (Asymmetric e¤ect of positive and bad news on beliefs at t = 1.) Consider the

1`o equilibrium where ¸ <

1

2

and

1

2

< ¸ (i.e., there is feedback). (i) If o = H and the

speculator is present, the manager’s expected posterior probability of the high state is ¡

H;spec

=

2

3

and is independent of `. (ii) If o = 1 and the speculator is present, the manager’s expected

posterior probability of the high state is ¡

L;spec

=

1

63

+

1

3

and is decreasing in `. (iii) We have

¡

H;spec

+ ¡

L;spec

2

=

1 +

1

63

2

. (15)

which is decreasing in `. Since

1+

1

63

2

1

2

, (15) implies that c/:

_

¡

H;spec

÷¸

_

÷c/:

_

¡

L;spec

÷¸

_

0, i.e. the absolute increase in the manager’s posterior if the speculator receives good news ex-

ceeds the absolute decrease in his posterior if the speculator receives bad news. The di¤erence

is decreasing in `.

Proof. See Appendix A.

Proposition 5 shows that, conditional upon the speculator being present, the impact on

beliefs of good news is greater in absolute terms than the impact of bad news. The asymmetry

is monotonically decreasing in the frequency of the speculator’s presence `. This result holds

24

even though the manager is rational and takes into account the fact that the speculator trades

asymmetrically when using the order ‡ow to update his prior. The source of the result is that,

even though the manager is rational, he is unable to distinguish the case of a negatively-informed

(and non-trading) speculator from that of an absent speculator (i.e. no information) – both

of these cases lead to the order ‡ow being ¦÷1. 0. 1¦ with uniform probability. Thus, negative

information has a smaller e¤ect on his belief. By contrast, if the speculator is always present,

the manager has no such inference problem and there is no asymmetry. This can be seen by

plugging ` = 1 into equation (15), in which case the average posterior equals the prior of

1

2

and

so we have c/:

_

¡

H;spec

÷¸

_

= c/:

_

¡

L;spec

÷¸

_

. Just as ` < 1 was a necessary condition for the

asymmetric feedback equilibrium to be the only equilibrium in the …rst place, it is a necessary

and su¢cient condition for bad news to have a smaller e¤ect on the manager’s belief than good

news.

The above analysis considered the change in the manager’s posterior at t = 1. At t = 2, the

state is realized and the posterior becomes either 1 (if o = H) or 0 (if o = 1). Since bad news

is conveyed to the manager to a lesser extent at t = 1, it seeps out to a greater extent ex post,

between t = 1 and t = 2. Thus, bad news causes a greater change in the posterior between

t = 1 and t = 2 than good news. This result is stated in Corollary 1 below:

Corollary 1 (Asymmetric e¤ect of high and low state realization on beliefs at t = 2). Consider

the 1`o equilibrium where ¸ <

1

2

and

1

2

< ¸ (i.e., there is feedback). The absolute impact

on beliefs between t = 1 and t = 2 of the realization of the state is greater for the low state

o = 1 than for the high state o = H, i.e.

c/:

_

0 ÷¡

L;spec

_

÷c/:

_

1 ÷¡

H;spec

_

0.

The asymmetry is monotonically decreasing in the frequency of the speculator’s presence `.

Proof. Follows from simple calculations

The smaller e¤ect of bad news on the posterior at t = 1 is counterbalanced by its larger

e¤ect at t = 2. As we will show in Section 4.2, surprisingly this result need not hold when we

examine the e¤ect of news on prices rather than posteriors.

4.2 Stock Returns

We now calculate the impact of the state realization and news on prices, in order to generate

stock return implications. We study short-run stock returns between t = 0 and t = 1, and long-

run drift between t = 1 and t = 2. While this analysis is similar to Section 4.1 but studying

prices rather than beliefs, we will show that not all the results remain the same.

25

4.2.1 Short-Run Stock Returns

Even though the speculator trades asymmetrically, this need not imply that realizations of

the high and low states will have a di¤erential price impact, since the market maker takes

into account the speculator’s trading strategy when devising his pricing function. Lemma 4 is

analogous to Lemma 3 and shows that, unconditionally, the good and bad states have the same

absolute impact on prices. Let j

0

denote the “ex ante” stock price at t = 0, before the state

has been realized.

Lemma 4 Consider the 1`o equilibrium where ¸ <

1

2

and

1

2

< ¸ (i.e., there is feedback):

(i) The stock price impact of the high state being realized is j

H

1

÷j

0

=

6

[j (2) ÷j (÷1)] 0.

(ii) The stock price impact of the low state being realized is j

L

1

÷ j

0

=

6

[j (÷1) ÷j (2)] <

0 = ÷

_

j

H

1

÷j

0

_

.

Proof. See Appendix A.

We have j

H

1

÷ j

0

= ÷

_

j

L

1

÷j

0

_

: the negative e¤ect of the low state equals the positive

e¤ect of the high state. Thus, the unconditional expected return is zero. This is an inevitable

consequence of market e¢ciency. The price at t = 0 is an unbiased expectation of the t = 1

expected price in the high state and the t = 1 expected price in the low state. Since both states

are equally likely, the absolute e¤ect of the high state must equal the absolute e¤ect of the low

state. An uninformed investor cannot trade the stock at t = 0 and expect a non-zero average

return at t = 1.

Proposition 6 is analogous to Proposition 5 and shows that, conditional on the speculator

being present, good news has a greater e¤ect than bad news:

Proposition 6 (Asymmetric e¤ect of positive and bad news on returns between t = 0 and

t = 1.) Consider the 1`o equilibrium where ¸ <

1

2

and

1

2

< ¸ (i.e., there is feedback):

(i) If o = H and the speculator is present, the average return between t = 0 and t = 1 is

j

H;spec

1

÷j

0

=

1

3

_

1 ÷

2

_

(j (2) ÷j (÷1)) 0.

(ii) If o = 1 and the speculator is present, the average return between t = 0 and t = 1 is

j

L;spec

1

÷j

0

=

6

(j (÷1) ÷j (2)) < 0.

(iii) The di¤erence in the absolute average returns between the speculator learning o = H

and o = 1 is given by:

c/:

_

j

H;spec

1

÷j

0

_

÷c/:

_

j

L;spec

1

÷j

0

_

=

1

3

(1 ÷`) (j (2) ÷j (÷1)) 0. (16)

i.e. the stock price increase upon good news exceeds the stock price decrease upon bad news.

This di¤erence is decreasing in `.

(iv) The average return, conditional on the speculator being present, is positive:

j

spec

1

÷j

0

=

1

3

1 ÷`

2

(j (2) ÷j (÷1)) 0. (17)

26

This di¤erence is decreasing in `.

Proof. See Appendix A.

Proposition 6 states that the average return, conditional on the speculator being present, is

positive – i.e. the stock price increase upon positive information exceeds the stock price decrease

upon negative information (part (iii)). Put di¤erently, positive information is impounded into

prices to a greater degree than negative information. Since good and bad news are equally likely,

this means that the average return, conditional on the speculator being present, is positive (part

(iv)). As with Proposition 5, the key to this result is that, even though the market maker is

rational, he is unable to distinguish the case of a negatively-informed speculator from that of

an absent speculator (i.e. no information). If ` = 1, equations (16) and (17) become zero

and there is no asymmetry; the asymmetry is monotonically decreasing in `. Note that the

positive average return given in part (iv) is not inconsistent with market e¢ciency, because it

is conditional upon the speculator being present, which is private information. An uninformed

investor cannot buy the stock at t = 0 and expect to earn a positive return at t = 1 because

she will not know whether the speculator is present.

4.2.2 Long-Run Drift

We now move from short-run returns to calculating the long-run drift of the stock price, to

analyze the stock return analog of Corollary 1, i.e., the impact of the state realization on prices

between t = 1 and t = 2. Corollary 1 showed that the smaller e¤ect of bad news on beliefs at

t = 1 is counterbalanced by a larger e¤ect on beliefs at t = 2. Corollary 2 below shows that

this need not be the case for returns: it is possible for bad news to have a smaller e¤ect than

good news at both t = 1 and t = 2.

Corollary 2 (Asymmetric e¤ect of positive and bad news on returns between t = 1 and t = 2).

Consider the 1`o equilibrium where ¸ <

1

2

and

1

2

< ¸ (i.e., there is feedback):

(i) If o = H and the speculator is present, the average return between t = 1 and t = 2 is

j

H;spec

2

÷j

H;spec

1

=

1

3

(1

i

H

÷1

i

L

) 0.

(ii) If o = 1 and the speculator is present, the average return between t = 1 and t = 2 is

j

L;spec

2

÷j

L;spec

1

= ÷

1

3

_

1

i

H

÷1

i

L

_

÷

1

3

_

1 ÷`

2 ÷`

(1

n

H

÷1

n

L

)

_

. (18)

which is negative in Case 1, but can be positive or negative in Case 2.

(iii) If (18) < 0, the di¤erence in the absolute average returns between the speculator learning

o = H and o = 1 is given by:

c/:

_

j

H;spec

2

÷j

H;spec

1

_

÷c/:

_

j

L;spec

2

÷j

L;spec

1

_

=

1

3

_

1 ÷`

2 ÷`

(1

n

L

÷1

n

H

)

_

.

27

which is positive in Case 2 and negative in Case 1. The magnitude of the di¤erence is decreasing

in `.

(iv) Expected …rm value at t = 2, conditional upon the speculator being present, is :

j

spec

2

=

1

2

1

i

H

+

1

3

1

i

L

+

1

6

1

n

L

.

and the average return between t = 1 and t = 2 if the speculator is present is:

j

spec

2

÷j

spec

1

=

1

6

1 ÷`

2 ÷`

(1

n

L

÷1

n

H

) ,

which is positive in Case 2 and negative in Case 1. The magnitude of the di¤erence is decreasing

in `.

Proof. See Appendix A.

Corollary 1 showed that, if the speculator is present, good news has a larger e¤ect on beliefs

at t = 1 than bad news, because she trades on the former but not the latter; thus, the expected

change in beliefs between t = 0 and t = 1 is positive. Since bad news has a smaller e¤ect at

t = 1, it must have a larger e¤ect at t = 2 (since the truth about the state comes out at t = 2),

and so the average increase in beliefs between t = 0 and t = 1 is reversed by an average decrease

in beliefs between t = 1 and t = 2. Corollary 2 shows that this need not be the case when we

study prices rather than beliefs: the speculator’s presence can lead to positive average returns

in both the short-run (between t = 0 and t = 1) and also in the long-run (between t = 1 and

t = 2). This is because the stock price depends not only on the beliefs about the state, but

also the manager’s action. Thus, there is an additional e¤ect of the speculator on prices that

does not exist in the analysis of beliefs: not only does she convey information about the state,

but also this information improves the manager’s decision-making and enhances …rm value –

the essence of the feedback e¤ect. In Case 2 (1

n

H

< 1

n

L

), this feedback e¤ect is su¢ciently

strong to turn the average return between t = 1 and t = 2 positive. In state 1, little bad news

emerges about the state between t = 0 and t = 1, which means that there is a large amount

of bad news to come out between t = 1 and t = 2; this in turn leads to the large downward

revision in beliefs in Corollary 1. However, the e¤ect on prices in Corollary 2 is muted because

the damage to …rm value caused by state 1 can be mitigated by taking the corrective action.

Thus, the negative e¤ect of bad news is smaller than the positive e¤ect of good news between

t = 1 and t = 2 as well as between t = 0 and t = 1 due to the feedback e¤ect. Indeed, if the

feedback e¤ect is su¢ciently strong, i.e. 1

n

L

is much higher than 1

n

H

, the return to bad news

between t = 1 and t = 2 can be positive ((18) 0). By contrast, in Case 1, (1

n

H

1

n

L

), the

long-run drift to the low state is larger in magnitude, analogous to Corollary 1. Since state 1

is bad for …rm value regardless of whether the manager takes the corrective action or not, the

realization of state 1 at t = 2 leads to a large decrease in prices.

28

The analysis thus far has considered the impact of news on prices at t = 1 and t = 2. We

now consider the impact of investment (a real variable) on prices; speci…cally, the extent to

which it is impounded into prices at t = 1 or at t = 2. While Section 4.2.1 showed that good

news received by the speculator has a greater short-run price impact than bad news, Proposition

7 now demonstrates a related result: the proportion of the total returns to an investment that

is realized in the short-run (at t = 1) rather than the long-run (at t = 2) is greater for a good

investment (o = H) than a bad investment (o = 1). In other words, the price impact of a good

investment is more front-loaded than for a bad investment.

Proposition 7 (Faster incorporation into prices of good investment than bad investment.)

Consider the 1`o equilibrium where ¸ <

1

2

and

1

2

< ¸ (i.e., there is feedback):

(i) If investment is undertaken in state H:

(ia) The average return between t = 0 and t = 1 is

j

i;H

1

÷j

0

=

1

6(2 + `)

[(2 + 2` ÷`

2

)1

i

H

+ (2 ÷2`)1

i

L

÷(2 ÷` ÷`

2

)1

n

H

÷(2 + `)1

n

L

] 0. (19)

(ib) The average return between t = 1 and t = 2 is

1

i

H

÷j

i;H

1

=

1

i

H

÷1

i

L

2 + `

0. (20)

(ii) If investment is undertaken in state 1:

(iia) The average return between t = 0 and t = 1 is

1

6

[(1 ÷`)

_

1

i

H

÷1

n

H

_

+ 1

i

L

÷1

n

L

] < 0. (21)

(iib) The average return between t = 1 and t = 2 is

1

i

L

÷j

i;H

1

= ÷

1

2

(1

i

H

÷1

i

L

) < 0. (22)

(iii) The returns to a good investment manifest more rapidly (i.e., to a greater degree at

t = 1) than the returns to a bad investment, i.e., c/: ((22) ÷(21)) c/: ((20) ÷(19)).

Proof. See Appendix A.

Parts (i) and (ii) of Proposition 7 show that investing in the high state leads to both positive

short-run returns between t = 0 and t = 1 and also positive long-run drift between t = 1 and

t = 2. Investing in the low state leads to negative short-run returns and negative long-run drift.

Part (iii) demonstrates that the returns to a good investment are realized to a greater extent at

t = 1 rather than t = 2, compared to a bad investment. Thus, the returns to a good investment

manifest more rapidly than the returns to a bad investment, i.e., are more front-loaded. To our

knowledge, this prediction has not yet been tested.

29

The intuition behind the asymmetry is di¤erent from Proposition 6. In both Propositions

6 and 7, the asymmetry occurs because the low state has a lesser impact on prices than the

high state. In Proposition 6, this arises from the fact that ` < 1, which means that the

market maker cannot distinguish the case of a negatively-informed speculator from that of an

uninformed speculator. Here, the intuition is as follows. If the investment is bad, the negative

returns cannot manifest too strongly at t = 1, otherwise the decline in the stock price will have

led to the investment being canceled. Thus, the negative returns must manifest predominantly

at t = 2. Put di¤erently, there are bad investments that do not lead to a sharply negative

reaction at t = 1 because the speculator did not trade on the bad news. Instead, the value-

destructiveness of the investment seeps out ex post. Note that the long-term drift in returns

does not violate market e¢ciency. The key to reconciling this result with market e¢ciency is

that …rm value is endogenous to trading. If speculators sold aggressively in response to a bad

investment, the decline in the stock price will lead to the investment being cancelled. Thus,

the negative returns must manifest predominantly at t = 2.

5 Summary of Implications

This section discusses several implications of our model. The …rst is that this paper identi…es

a limit to arbitrage which, in contrast to alternative explanations, is likely to persist over

time even as markets evolve and investors become more sophisticated. One existing source of

limited arbitrage is market frictions such as short-sales constraints, which will likely diminish

with the development of …nancial markets. A second is that investors in professional money

managers make their allocation decisions based on short-run measures of performance, which

leads to mutual funds avoiding arbitrage trading that will only converge in the long run (Shleifer

and Vishny (1997)). Such behavior can either be irrational over-extrapolation, or rational if

investors have limited information on the fund manager’s quality but instead must infer it

imperfectly from short-run performance. Either way, if investor sophistication and information

improve over time, this force will also diminish.

By contrast, the limit to arbitrage analyzed by this paper stems from …rm value being

endogenous to the act of arbitrage. This is a fundamental force that does not rely on short-sale

constraints, investor irrationality or investors’ limited information on the quality of a portfolio

manager, and so may continue to persist over time. (The only market imperfection that our

model requires is trading costs, which exist even in developed …nancial markets). There is no

exogenous friction preventing the arbitrageur from trading; instead, she endogenously chooses

not to trade because of the feedback e¤ect. All agents in the model act with full rationality:

the market maker takes into account the manager’s learning when setting the price, and this in

turn a¤ects the speculator’s decision to trade; the market maker knows that the speculator is

pursuing an asymmetric trading strategy. If anything, the limit to arbitrage may increase with

investor sophistication, as this augments the extent to which speculators have value-relevant

30

information which the manager attempts to learn by observing the price.

The second main category of applications stems from the fact that the limit to arbitrage

is asymmetric. While the speculator buys on good information, she does not sell on bad in-

formation. This prediction has implications for trading volume, suggesting that volume should

be higher upon good investments (such as M&A or capital expenditure) than bad investments.

Such a relation is consistent with the well-documented positive correlation between trading

volume and stock returns (see, e.g., Karpo¤ (1987)). Moreover, even though the market maker

takes the asymmetric trading volume into account, Proposition 6 shows that negative informa-

tion will enter into prices more slowly, as found empirically by Hong, Lim, and Stein (2000).

While Hong, Lim, and Stein’s results are consistent with the Hong and Stein (1999) model

that news travels more slowly in small …rms with low analyst coverage, Hong and Stein do not

predict an asymmetry between good and bad news.

8

Hong, Lim, and Stein speculate that the

asymmetry arises because key information is held by the …rm’s managers, and they dissem-

inate favorable information more enthusiastically than unfavorable information because they

are evaluated according to the stock price. Our theoretical model o¤ers a potential alternative

explanation. Key information is held by a …rm’s investors, who disseminate information not

through public news releases, but by trading on it. Their reluctance to disseminate bad news

is not because they are evaluated according to the stock price, but due to the limit to arbitrage

created by the feedback e¤ect. Another di¤erence is that, in an underreaction model, if bad

news has a smaller e¤ect on short-run returns than good news, it must be counterbalanced by

a larger long-run drift. By contrast, Corollary 2 shows that, in some cases, bad news generates

a smaller e¤ect on returns in both the short-run and long-run. Even though less bad news is

transmitted to the market at t = 1, meaning that there is more to come out at t = 2, stock

returns depend not only on the state, but also the manager’s decision. In our feedback model,

the manager can take a corrective action to mitigate the negative impact of the state on …rm

value, so the e¤ect of bad news on returns is lower at t = 2 as well as at t = 1. While the

above results are unconditional on investment occurring, the model also generates implications

for the short- and long-run returns to investment. Proposition 7 shows that the returns to

good investment are more front-loaded than the returns to a bad investment, because the spec-

ulator trades more readily on good news than bad news. Thus, the value-destructiveness of a

bad investment seeps out to a greater extent ex post, leading to negative long-run returns as

documented by Agrawal, Ja¤e, and Mandelker (1992) and Rau and Vermaelen (1998).

Moreover, the feedback e¤ect means that the lack of negative information in prices will

have further consequences on real decisions. In particular, if speculators choose not to trade on

negative information, then such negative information does not become incorporated into stock

prices and fails to in‡uence the manager’s behavior. Thus, some negative-NPV projects will not

be optimally abandoned, leading to overinvestment – even though there is an agent who knows

8

Note that our paper focuses on the e¤ect of news on stock prices. It does not address the predictability of

future returns from past returns, which is another component of the Hong, Lim, and Stein (2000) …ndings.

31

with certainty that the investment is undesirable, it still takes place. In the model, even if

o = 1, we have d = i if the noise trader does not sell. Critically, overinvestment does not occur

because the manager is pursuing private bene…ts, as in the standard theories of Jensen (1986),

Stulz (1990) and Zwiebel (1996). In contrast, the manager is fully aligned with …rm value and

there are no agency problems. The manager wishes to maximize …rm value by learning from

prices, but is unable to do so since speculators refrain from impounding their information into

prices. Overinvestment occurs even though the manager is fully aware that the speculator does

not trade on negative information and takes this into account.

The above overinvestment result can apply to M&A as well as organic expansion. Luo

(2005) shows that managers sometimes use the market reaction to announced M&A deals to

guide whether they should cancel the acquisition. While he …nds that some transactions are

canceled in equilibrium, our model suggests that there are other negative-NPV deals that should

optimally be canceled but are not because speculators do not impound their negative views into

prices. This may explain why a large proportion of M&A deals destroy value (see, e.g., Andrade,

Mitchell and Sta¤ord (2001).)

6 Conclusion

This paper has modeled a limit to arbitrage that stems from the fact that …rm value is endoge-

nous to the act of exploiting the arbitrage. Even if a speculator has negative information on the

state, she may strategically refrain from trading on it, because doing so conveys her information

to the manager. The manager may then take a corrective action that improves …rm value but

reduces the pro…ts from her short position below the cost of trading, and sometimes causes her

to realize a loss. There are several important di¤erences between the feedback-driven limit to

arbitrage that we study, and the limits to arbitrage identi…ed by prior literature. First, unlike

limits to arbitrage based on fundamental risk, noise trader risk, or holding costs, our e¤ect is

asymmetric. Trading in either direction impounds information into prices, which improves the

manager’s decision-making and increases fundamental value. This increases the pro…tability of

a long position but reduces the pro…tability of a short position, thus encouraging buying on

good news but discouraging selling on bad news. Second, unlike limits to arbitrage based on

short-sale constraints, holding costs or portfolio delegation, our model does not rely on exoge-

nous forces or agency problems; instead, the e¤ect is generated endogenously as part of the

arbitrage process.

The asymmetry of our e¤ect has implications for both stock returns and real investment.

In terms of stock returns, bad news has a smaller e¤ect on short-run prices than good news,

even though the market maker is rational and takes the speculator’s trading strategy into

account when devising his pricing function. Interestingly, in contrast to underreaction models,

the smaller short-run reaction to bad news may also coincide with smaller long-run drift, since

the manager can take a corrective action to attenuate the negative e¤ect of the state on …rm

32

value. In addition, the returns to a good investment are more front-loaded than the returns

to a bad investment – since the speculator does not trade on negative information, the value-

destructiveness of a bad investment seeps out ex post. In terms of real investment, the manager

may overinvest in negative-NPV projects, even though there are no agency problems and he

is attempting to learn from the market to take the e¢cient decision. Even though there is

an agent in the economy who knows with certainty that the investment is undesirable, and

the manager is aware of the speculator’s asymmetric trading strategy, this information is not

conveyed to the manager and so the project is not abandoned.

33

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36

A Proofs

Proof of Proposition 1

This proof only provides supplementary material to what is in the text.

No Trade Equilibrium NT. The order ‡ows of A = ÷2 and A = 2 are o¤ the equilibrium

path and the posteriors are given by 0 and 1, respectively, as these are the only posteriors that

satisfy the Intuitive Criterion (as stated in the main proof). The order ‡ows of A ¸ ¦÷1. 0. 1¦

are observed on the equilibrium path and so the posteriors can be calculated by Bayes’ rule:

¡(A) = Pr(H[A)

=

Pr(A[H)

Pr(A[H) + Pr(A[1)

.

We thus have:

¡(÷1) =

`(1,3) + (1 ÷`)(1,3)

`(1,3) + (1 ÷`)(1,3) + `(1,3) + (1 ÷`)(1,3)

=

1

2

.

and ¡ (0) and ¡ (1) are calculated in exactly the same way. Sequential rationality leads to the

decisions d and prices j as given by the Table.

We now turn to calculating trading pro…ts. If the positively-informed speculator chooses to

deviate from not trading to buying:

« With probability (w.p.)

1

3

, A = 2 and she is fully revealed. Thus, trading pro…ts are zero.

« W.p.

1

3

, A = 1 and she pays

1

2

1

i

H

+

1

2

1

i

L

per share. The fundamental value of each share

is 1

i

H

, and so her pro…t is

1

2

(1

i

H

÷1

i

L

) 0.

« W.p.

1

3

, A = 0 and she pays

1

2

1

i

H

+

1

2

1

i

L

per share. The fundamental value of each share

is 1

i

H

, and so her pro…t is

1

2

(1

i

H

÷1

i

L

) 0.

Thus, her expected gross pro…t is given by:

1

3

1

2

_

1

i

H

÷1

i

L

_

+

1

3

1

2

_

1

i

H

÷1

i

L

_

=

1

3

_

1

i

H

÷1

i

L

_

= i

3

. (23)

A similar calculation shows that, if a negatively-informed speculator sells, her gross pro…t

is also given by (23). Thus, if and only if i _ i

3

, the no-trade equilibrium is sustainable.

Partial Trade Equilibrium SNB. The order ‡ow of A = 2 is o¤ the equilibrium path and

37

the posterior is given by 1. The posteriors of the other order ‡ows are given as follows:

¡(÷2) =

0

`(1,3)

= 0

¡ (÷1) =

`(1,3) + (1 ÷`)(1,3)

`(1,3) + (1 ÷`)(1,3) + `(1,3) + (1 ÷`)(1,3)

=

1

2

¡ (0) =

`(1,3) + (1 ÷`)(1,3)

`(1,3) + (1 ÷`)(1,3) + `(1,3) + (1 ÷`)(1,3)

=

1

2

¡(1) =

`(1,3) + (1 ÷`)(1,3)

`(1,3) + (1 ÷`)(1,3) + (1 ÷`)(1,3)

=

1

2 ÷`

.

Under this equilibrium, the negatively-informed speculator sells.

« W.p.

1

3

, A = ÷2 and she is fully revealed. Thus, trading pro…ts are zero.

« W.p.

1

3

, A = ÷1 and she receives

1

2

1

i

H

+

1

2

1

i

L

per share. The fundamental value of each

share is 1

i

L

, and so her pro…t is

1

2

(1

i

H

÷1

i

L

) 0.

« W.p.

1

3

, A = 0 and she receives

1

2

1

i

H

+

1

2

1

i

L

per share. The fundamental value of each

share is 1

i

L

, and so her pro…t is

1

2

(1

i

H

÷1

i

L

) 0.

Thus, her expected gross pro…t is given by:

1

3

_

1

i

H

÷1

i

L

_

= i

3

.

If the positively-informed speculator deviates to buying:

« W.p.

1

3

, A = 2 and she is fully revealed. Thus, trading pro…ts are zero.

« W.p.

1

3

, A = 1 and she pays

1

2

1

i

H

+

1

2

1

i

L

per share. The fundamental value of each

share is 1

i

H

, and so her pro…t is

1

2

(1

i

H

÷1

i

L

) 0.

« W.p.

1

3

, A = 0 and she pays

1

2

1

i

H

+

1

2

1

i

L

per share. The fundamental value of each share

is 1

i

H

, and so her pro…t is

1

2

(1

i

H

÷1

i

L

) 0.

Thus, her expected gross pro…t is given by:

1

3

_

1

2

+

1 ÷`

2 ÷`

_

_

1

i

H

÷1

i

L

_

= i

2

.

Thus, the SNB equilibrium is sustainable if and only if i

2

_ i < i

3

.

Partial Trade Equilibrium BNS. The order ‡ow of A = ÷2 is o¤ the equilibrium path and

38

the posterior is given by 0. The posteriors of the other order ‡ows are given as follows:

¡ (÷1) =

(1 ÷`)(1,3)

(1 ÷`)(1,3) + `(1,3) + (1 ÷`)(1,3)

=

1 ÷`

2 ÷`

¡ (0) =

`(1,3) + (1 ÷`)(1,3)

`(1,3) + (1 ÷`)(1,3) + `(1,3) + (1 ÷`)(1,3)

=

1

2

¡(1) =

`(1,3) + (1 ÷`)(1,3)

`(1,3) + (1 ÷`)(1,3) + `(1,3) + (1 ÷`)(1,3)

=

1

2

¡(2) =

`(1,3)

`(1,3)

= 1.

There are two sub-cases to consider. In the sub-case of no feedback (

1

2

¸), decision

d = i is taken for all of the order ‡ows on the equilibrium path. Thus, analogous to the SNB

equilibrium, informed trading (in this case, buying on good information) yields pro…ts of i

3

;

if the negatively-informed speculator deviates to selling, she earns pro…ts of i

2

. Hence, this

equilibrium is sustainable if and only if i

2

_ i < i

3

. For the sub-case of feedback (

1

2

< ¸),

the manager now takes decision d = : upon observing order ‡ow A = ÷1. The pro…ts from

trading on positive information are unchanged. The pro…ts from deviating to selling on negative

information are now given as follows:

« W.p.

1

3

, A = ÷2 and she is fully revealed. Thus, trading pro…ts are zero.

« W.p.

1

3

, A = ÷1 and she receives

1

2

1

n

H

+

1

2

1

n

L

per share. The fundamental value

of each share is 1

n

L

because the manager is now taking the corrective action, and so her

pro…t is

1

2

(1

n

H

÷1

n

L

) 0.

« W.p.

1

3

, A = 0 and she receives

1

2

1

i

H

+

1

2

1

i

L

per share. The fundamental value of each

share is 1

i

L

, and so her pro…t is

1

2

(1

i

H

÷1

i

L

) 0.

Thus, her expected gross pro…t is given by:

1

3

_

1

2

_

1

i

H

÷1

i

L

_

+

1 ÷`

2 ÷`

(1

n

H

÷1

n

L

)

_

= i

1

.

Thus, this equilibrium is sustainable if and only if i

1

_ i < i

3

.

Trade Equilibrium T. All order ‡ows are on the equilibrium path and so the posteriors are

39

given as follows:

¡(÷2) =

0

`(1,3)

= 0

¡ (÷1) =

(1 ÷`)(1,3)

(1 ÷`)(1,3) + `(1,3) + (1 ÷`)(1,3)

=

1 ÷`

2 ÷`

¡ (0) =

`(1,3) + (1 ÷`)(1,3)

`(1,3) + (1 ÷`)(1,3) + `(1,3) + (1 ÷`)(1,3)

=

1

2

¡(1) =

`(1,3) + (1 ÷`)(1,3)

`(1,3) + (1 ÷`)(1,3) + (1 ÷`)(1,3)

=

1

2 ÷`

¡(2) =

`(1,3)

`(1,3)

= 1.

The pro…ts from buying on positive information are given by i

2

, as in the o`1 equilibrium.

For the pro…ts from selling on negative information, there are two sub-cases to consider, which

correspond to the two sub-cases in the 1`o equilibrium. Without feedback (

1

2

¸), the

pro…ts are given by i

2

and so the equilibrium is sustainable if and only if i < i

2

. With feedback

(

1

2

¸), the pro…ts are given by i

1

and so the equilibrium is sustainable if and only if i < i

1

.

Proof of Proposition 3

This proof only provides supplementary material to what is in the text. As discussed in the

main text, it is straightforward to show that the negatively-informed speculator will not deviate

to buying. Here we calculate the pro…ts made if the positively-informed speculator deviates to

selling, to derive the necessary conditions to prevent such a deviation.

No Trade Equilibrium NT.

If the positively-informed speculator deviates to selling:

« W.p.

1

3

, A = ÷2 and she receives 1

n

L

for a share that is worth 1

n

H

, which yields a pro…t

of (1

n

L

÷1

n

H

) 0.

« W.p.

1

3

, A = ÷1 and she receives

1

2

1

i

H

+

1

2

1

i

L

for a share that is worth 1

i

H

, which yields

a pro…t of

1

2

(1

i

L

÷1

i

H

) < 0.

« W.p.

1

3

, A = 0 and she receives

1

2

1

i

H

+

1

2

1

i

L

for a share that is worth 1

i

H

, which yields a

pro…t of

1

2

(1

i

L

÷1

i

H

) < 0.

Thus, her overall pro…ts are given by

1

3

(1

n

L

÷1

n

H

) +

1

3

_

1

i

L

÷1

i

H

_

.

For the positively-informed speculator not to deviate to selling, we require

1

3

_

÷

_

1

i

H

÷1

i

L

_

+ (1

n

L

÷1

n

H

)

_

< i.

40

The calculations for the Partial Trade Equilibrium o`1 are identical.

Partial Trade Equilibrium BNS.

If the positively-informed speculator deviates to selling:

« W.p.

1

3

, A = ÷2 and she receives 1

n

L

for a share that is worth 1

n

H

, which yields a pro…t

of (1

n

L

÷1

n

H

) 0.

« W.p.

1

3

, A = ÷1. In the case of feedback (

1

2

< ¸ ), she receives

1

2

1

n

H

+

1

2

1

n

L

for

a share that is worth 1

n

H

, which yields a pro…t of

1

2

(1

n

L

÷1

n

H

) 0. In the case of no

feedback (

1

2

¸ ), she receives

1

2

1

i

H

+

1

2

1

i

L

for a share that is worth 1

i

H

, which

yields a pro…t of

1

2

(1

i

L

÷1

i

H

) < 0.

« W.p.

1

3

, A = 0 and she receives

1

2

1

i

H

+

1

2

1

i

L

for a share that is worth 1

i

H

, which yields a

pro…t of

1

2

(1

i

L

÷1

i

H

) < 0.

In the case of feedback, her overall pro…ts are given by

1

3

(1

n

L

÷1

n

H

) +

1

3

1

2 ÷`

(1

n

L

÷1

n

H

) +

1

3

_

1

2

_

1

i

L

÷1

i

H

_

_

=

1

3

_

3 ÷`

2 ÷`

(1

n

L

÷1

n

H

)

_

÷

1

3

_

1

2

_

1

i

H

÷1

i

L

_

_

.

For the positively-informed speculator to choose buying over selling, her pro…ts must be

greater under the former. This requires:

1

3

_

1

i

H

÷1

i

L

_

1

3

_

3 ÷`

2 ÷`

(1

n

L

÷1

n

H

)

_

÷

1

3

_

1

2

_

1

i

H

÷1

i

L

_

_

3

2

_

1

i

H

÷1

i

L

_

3 ÷`

2 ÷`

(1

n

L

÷1

n

H

) .

The …rst term is the “fundamental” e¤ect, which represents the pro…ts from trading in the

direction of one’s private information. The second term is the “feedback” e¤ect, which arises

because selling manipulates the order ‡ow and causes the manager to take the wrong decision.

This yields the condition

63

62

(1

i

H

÷1

i

L

) 1 in the Proposition.

In the case of no feedback, her overall pro…ts are given by

1

3

(1

n

L

÷1

n

H

) +

1

3

1

2 ÷`

_

1

i

L

÷1

i

H

_

+

1

3

_

1

2

_

1

i

L

÷1

i

H

_

_

=

1

3

(1

n

L

÷1

n

H

) ÷

1

3

_

4 ÷`

4 ÷2`

_

1

i

H

÷1

i

L

_

_

.

41

For the positively-informed speculator to choose buying over selling, we require:

1

3

_

1

i

H

÷1

i

L

_

1

3

(1

n

L

÷1

n

H

) ÷

1

3

_

4 ÷`

4 ÷2`

_

1

i

H

÷1

i

L

_

_

8 ÷3`

4 ÷2`

1

i

H

÷1

i

L

1

n

L

÷1

n

H

1.

Trade Equilibrium T.

If the positively-informed speculator deviates to selling, the calculations are exactly the

same as in the Partial Trade Equilibrium 1`o. However, the pro…ts from buying (that we

need to compare against the pro…ts from selling) are di¤erent.

In the case of feedback, for the positively-informed speculator to choose buying over selling,

we require:

1

3

_

1

2

+

1 ÷`

2 ÷`

_

_

1

i

H

÷1

i

L

_

1

3

_

3 ÷`

2 ÷`

(1

n

L

÷1

n

H

)

_

÷

1

3

_

1

2

_

1

i

H

÷1

i

L

_

_

3 ÷2`

3 ÷`

1

i

H

÷1

i

L

1

n

L

÷1

n

H

1.

In the case of no feedback, for the positively-informed speculator to choose buying over

selling, we require:

1

3

_

1

2

+

1 ÷`

2 ÷`

_

_

1

i

H

÷1

i

L

_

1

3

(1

n

L

÷1

n

H

) ÷

1

3

_

4 ÷`

4 ÷2`

_

1

i

H

÷1

i

L

_

_

2

1

i

H

÷1

i

L

1

n

L

÷1

n

H

1.

Proof of Lemma 3

For part (i), if o = H, the expected posterior is given by:

¡

H

= (1 ÷`)

_

1

3

¡ (÷1) +

1

3

¡ (0) +

1

3

¡ (1)

_

+ `

_

1

3

¡ (0) +

1

3

¡ (1) +

1

3

¡ (2)

_

=

1 ÷`

3

¡ (÷1) +

1

3

¡ (0) +

1

3

¡ (1) +

`

3

¡ (2)

=

(1 ÷`)

2

6 ÷3`

+

1

3

+

`

3

. (24)

42

We have:

J¡

H

J`

=

1

3

+

1

3

_

÷2(1 ÷`)(2 ÷`) + (1 ÷`)

2

(2 ÷`)

2

_

=

1

3

_

1 +

_

1 ÷`

2 ÷`

_

2

÷2

1 ÷`

2 ÷`

_

=

1

3

_

1 ÷

_

1 ÷`

2 ÷`

__

2

0.

The expected posterior is increasing in `: if the speculator is more likely to be present, she

is more likely to impound her information into prices by trading.

Moving to part (ii), if o = 1, we have:

¡

L

=

1

3

(¡ (÷1) + ¡ (0) + ¡ (1))

=

1 ÷`

6 ÷3`

+

1

3

. (25)

This is decreasing in `. Even though the speculator does not trade upon o = 1 if she is present,

her information is still partially incorporated into prices. With o = 1, there is a

1

3

probability

that the order ‡ow is A = ÷1. This is consistent with the speculator being absent (in which

case the state may be either H or 1) or her being present and observing o = 1; it is not

consistent with the speculator observing o = H. The greater the likelihood that the speculator

is present, the greater the likelihood that A = ÷1 stems from o = 1, and thus the greater the

decrease in the market maker’s posterior. Part (iii) follows from simple calculations.

Proof of Proposition 5

For parts (i) and (ii), we have:

¡

H;spec

=

1

3

(¡ (0) + ¡ (1) + ¡ (2))

=

2

3

. (26)

¡

L;spec

=

1

3

(¡ (÷1) + ¡ (0) + ¡ (1))

=

1 ÷`

6 ÷3`

+

1

3

. (27)

Note that ¡

H;spec

is independent of `, but ¡

L;spec

is decreasing in `. The variable ` can a¤ect

the expected posterior in two ways: …rst, it can change the relative likelihood of the di¤erent

order ‡ows, and second, it can change the actual posterior given a certain order ‡ow. Since we

are conditioning on the speculator being present, the …rst channel is ruled out: conditional on

the speculator being present and o = H, A ¸ ¦0. 1. 2¦ with uniform probability regardless of `;

43

conditional on the speculator being present and o = 1, A ¸ ¦÷1. 0. 1¦ with uniform probability

regardless of `. Turning to the second channel, the only posterior that depends on ` is ¡ (÷1):

since A = ÷1 is inconsistent with the speculator being present and seeing o = H, it has a

particularly negative impact on the likelihood of o = H if the speculator is more likely to be

present. By contrast, A ¸ ¦÷2. 2¦ is fully revealing and so the posterior is independent of `;

A ¸ ¦0. 1¦ is completely uninformative and so the posterior is again independent of `. Since

A = ÷1 can only occur in the presence of a speculator if she has received bad news, only ¡

L;spec

depends on ` but ¡

L;spec

does not. Part (iii) follows from simple calculations.

Proof of Lemma 4

We start by calculating j

0

. With probability

1

2

, the state will be o = 1 and there is no trade,

regardless of whether the speculator is present. Thus, A ¸ ¦÷1. 0. 1¦ with equal probability.

With probability

1

2

, the state will be o = H. If the speculator is absent (w.p. (1 ÷`)), there is

no trade and we again have A ¸ ¦÷1. 0. 1¦. If the speculator is present, A ¸ ¦0. 1. 2¦. Letting

j (A) denote the stock price set by the market maker after observing order ‡ow A at t = 1,

the price at t = 0 will be the expectation over all possible future prices at t = 1, and is given

as follows:

j

0

=

`

2

_

1

3

j (0) +

1

3

j (1) +

1

3

j (2)

_

+

_

1 ÷

`

2

__

1

3

j (÷1) +

1

3

j (0) +

1

3

j (1)

_

=

1

3

__

1 ÷

`

2

_

j (÷1) + j (0) + j (1) +

`

2

j (2)

_

=

1

6

_

(1 ÷`)1

n

H

+ 1

n

L

+ (2 + `)1

i

H

+ 21

i

L

¸

. (28)

Even though the initial belief ¸ is independent of `, the initial stock price j

0

is increasing in

`, because the speculator provides information to improve the manager’s decision. Moreover,

@p

0

@

is increasing in (1

i

H

÷1

n

H

), the increase in …rm value from taking the e¢cient continuation

decision in the high state. This is intuitive. If the speculator is present, she always buys in

state H, which guarantees that A _ 0 and the investment is undertaken. If she is absent, there

is a possibility that A = ÷1. This leads the manager to take the suboptimal corrective action,

reducing …rm value by (1

i

H

÷1

n

H

). By contrast,

@p

0

@

is independent of 1

i

L

and 1

n

L

, the …rm

values in the low state. This is because, if the low state is realized, the speculator’s presence

does nothing to help the manager’s decision, since she does not trade.

For part (i), if o = H is realized, the expected price at t = 1 is given by:

j

H

1

= (1 ÷`)

_

1

3

j (÷1) +

1

3

j (0) +

1

3

j (1)

_

+ `

_

1

3

j (0) +

1

3

j (1) +

1

3

j (2)

_

=

1 ÷`

3

j (÷1) +

1

3

j (0) +

1

3

j (1) +

`

3

j (2) . (29)

44

Note that:

Jj

H

1

J`

=

1

3

j(2) ÷

1

3

j(÷1) +

1 ÷`

3

Jj(÷1)

J`

=

1

3

_

1

i

H

÷

1

(2 ÷`)

2

1

n

L

÷

_

1 ÷

1

(2 ÷`)

2

_

1

n

H

_

1

3

[1

i

H

÷1

n

L

]

0.

i.e. j

H

1

is increasing in `, since the speculator impounds information about the high state into

prices.

Turning to part (ii), if o = 1is realized, the expected price at t = 1 is given by:

j

L

1

=

1

3

(j (÷1) + j (0) + j (1)) . (30)

We have

@p

L

1

@

=

R

n

L

R

n

H

3(2)

2

. If the speculator is more likely to be present, then A = ÷1 is more

likely to result from o = 1. Thus, the price is higher if and only if …rm value is higher in this

state, i.e., 1

n

L

1

n

H

(Case 2).

The calculations of j

H

1

÷j

0

and j

L

1

÷j

0

follow automatically.

Proof of Proposition 6

For part (i), if the speculator receives positive information, she will buy one share and so

the expected price becomes:

j

H;spec

1

=

1

3

(j (0) + j (1) + j (2)) . (31)

Unlike j

H

1

(equation (29)), this is independent of `, for the same reasons that ¡

H;spec

(equa-

tion (26)) is independent of `. The stock return realized when the speculator receives good

information is thus given by:

j

H;spec

1

÷j

0

=

1

3

(j (0) + j (1) + j (2)) ÷

1

3

__

1 ÷

`

2

_

j (÷1) + j (0) + j (1) +

`

2

j (2)

_

=

1

3

_

1 ÷

`

2

_

(j (2) ÷j (÷1))

=

1

3

_

1 ÷

`

2

__

1

i

H

÷

1 ÷`

2 ÷`

1

n

H

÷

1

2 ÷`

1

n

L

_

0, (32)

and we have

J

_

j

H;spec

1

÷j

0

_

J`

=

1

6

[1

n

H

÷1

i

H

] < 0.

Equation (32) is decreasing in `, whereas the stock return not conditioning on the specula-

45

tor’s presence, (32), was increasing in `. This is because j

0

is increasing in `, but j

H;spec

1

is

independent of `.

For part (ii), if the speculator is present and receives negative information, we have:

j

L;spec

1

=

1

3

(j (÷1) + j (0) + j (1)) = j

L

1

. (33)

and

j

L;spec

1

÷j

0

=

1

3

(j (÷1) + j (0) + j (1)) ÷

1

3

__

1 ÷

`

2

_

j (÷1) + j (0) + j (1) +

`

2

j (2)

_

=

`

6

(j (÷1) ÷j (2)) = j

L

1

÷j

0

< 0.

Parts (iii) and (iv) follow from simple calculations.

Dropping constants, both equation (16) (the asymmetry between the price impact of good

and bad news) and equation (17) (the average return, conditional on the speculator being

present) become:

(1 ÷`)

_

1

i

H

÷

1 ÷`

2 ÷`

1

n

H

÷

1

2 ÷`

1

n

L

_

.

Di¤erentiating with respect to ` gives:

÷1

i

H

+

1 ÷`

2 ÷`

1

n

H

+

1

2 ÷`

1

n

L

+ (1 ÷`)

_

1

(2 ÷`)

2

1

n

H

÷

1

(2 ÷`)

2

1

n

L

_

= ÷1

i

H

+

3 ÷4` + `

2

(2 ÷`)

2

1

n

H

+

1

(2 ÷`)

2

1

n

L

The coe¢cients of 1

n

H

and 1

n

L

are positive and add up to one. That is, we have a convex

combination of 1

n

H

and 1

n

L

, which is smaller that 1

i

H

, since 1

i

H

1

n

H

and 1

i

H

1

n

L

. Thus,

both equations (16) and (17) are decreasing in `.

Proof of Corollary 2

We start with part (i). If the speculator receives good news, she will buy and so the project

will always be undertaken. We thus have j

H;spec

2

= 1

i

H

. This yields:

j

H;spec

2

÷j

H;spec

1

= 1

i

H

÷

1

3

(j (0) + j (1) + j (2))

=

1

3

_

1

i

H

÷1

i

L

_

.

Moving to part (ii), if the speculator receives bad news, she will not trade. The project will

be cancelled if the noise trader sells, else it will be continued. We thus have j

L;spec

2

=

2

3

1

i

L

+

1

3

1

n

L

.

46

This yields:

j

L;spec

2

÷j

L;spec

1

=

2

3

1

i

L

+

1

3

1

n

L

÷

1

3

(j (÷1) + j (0) + j (1))

= ÷

1

3

_

1

i

H

÷1

i

L

_

÷

1

3

_

1 ÷`

2 ÷`

(1

n

H

÷1

n

L

)

_

.

which can be positive or negative. Part (iii) follows from simple calculations. For part (iv), we

…rst calculate the expected …rm value at t = 2 if the speculator is present, not conditioning on

the state. If o = H, the project is always undertaken, regardless of the order ‡ow at t = 1,

and so …rm value · = 1

i

H

. If o = 1, whether the project is undertaken depends on the order

‡ow: if A = ÷1, we have d = : and so · = 1

n

L

; if A ¸ ¦0. 1¦, we have d = i and so · = 1

i

L

.

Expected …rm value at t = 2 is thus given by:

j

spec

2

=

1

2

1

i

H

+

1

3

1

i

L

+

1

6

1

n

L

.

and so we have

j

spec

2

÷j

spec

1

=

1

6

1 ÷`

2 ÷`

(1

n

L

÷1

n

H

) ,

which is positive if we are in Case 2 and negative if we are in Case 1.

Proof of Proposition 7

We start with some preliminary results that will be useful in the main proof. From

1

2

< ¸

we have

` 1 ÷

¸

1 ÷¸

,

which implies that ` ¸ (1 ÷

1

. 1). Let `

min

= 1 ÷

1

and `

max

= 1.

De…ne [

~

1

i

H

~

1

i

L

~

1

n

L

] = [1

i

H

÷1

n

H

1

i

L

÷1

n

H

1

n

L

÷1

n

H

]. Note that

~

1

i

H

0 from equation (1).

Equation (5) thus yields:

~

1

n

L

= (1 ÷`

min

)

~

1

i

H

+

~

1

i

L

. (34)

For part (i), we …rst calculate j

i;H

1

, the expected stock price at t = 1 if investment has been

undertaken and the state is good. We have o = H w.p.

1

2

. W.p. `, the speculator is present

and buys, so A ¸ ¦0. 1. 2¦ with uniform probability and the investment is always undertaken.

W.p. 1 ÷ ` the speculator is absent, so there is no trade, which yields A ¸ ¦÷1. 0. 1¦. If

A = ÷1, we have d = : so we exclude this case. We therefore have:

j

i;H

1

=

2

1

3

(j(0) + j(1) + j(2)) +

1

2

1

3

(j(0) + j(1))

1

2

_

` + (1 ÷`)

2

3

_

=

j(0) + j(1) + `j(2)

2 + `

.

Simple calculations show that j

i;H

1

is increasing in `: if the speculator is present, she will trade

on her positive signal and impound it into prices. Note that this argument did not apply to

47

¡

H;spec

(equation (26)) and j

H;spec

1

(equation (31)) because those quantities are conditional on

the speculator being present, so A = ¦0. 1. 2¦ were all equally likely. Here, A = 2 is particularly

likely if the speculator is present.

For part (ia), the short-run return to an investment (d = i) in the high state is given by:

j

i;H

1

÷j

0

=

`j(2) + j(1) + j(0)

2 + `

÷

1

3

__

1 ÷

`

2

_

j (÷1) + j (0) + j (1) +

`

2

j (2)

_

=

4` ÷`

2

6(2 + `)

j(2) +

1 ÷`

3(2 + `)

j(1) +

1 ÷`

3(2 + `)

j(0) ÷

_

1

3

÷

`

6

_

j(÷1)

=

1

6(2 + `)

[(2 + 2` ÷`

2

)1

i

H

+ (2 ÷2`)1

i

L

÷(2 ÷` ÷`

2

)1

n

H

÷(2 + `)1

n

L

]. (35)

The sign of (35) is the same as the sign of

(2 + 2` ÷`

2

)

_

1

i

H

÷1

n

H

_

+ (2 ÷2`)

_

1

i

L

÷1

n

H

_

÷(2 ÷` ÷`

2

) (1

n

H

÷1

n

H

) ÷(2 + `) (1

n

L

÷1

n

H

)

= (2 + 2` ÷`

2

)

~

1

i

H

+ (2 ÷2`)

~

1

i

L

÷(2 + `)

~

1

n

L

. (36)

Equation (36) is quadratic and concave in `, and so its minimum occurs at either `

min

or

`

max

. Thus, to prove that (36) 0, it is su¢cient to prove that it is positive at both `

min

and `

max

. At ` = `

max

, equation (36) reduces to 3

~

1

i

H

÷ 3

~

1

n

L

0. At ` = `

min

, it reduces to

3`

min

(

~

1

i

H

÷

~

1

i

L

) 0. Thus, equation (35) is positive.

For part (ib), the long-run drift is given by:

1

i

H

÷j

i;H

1

= 1

i

H

÷

`j(2) + j(1) + j(0)

2 + `

=

1

i

H

÷1

i

L

2 + `

0. (37)

For part (ii), we …rst calculate j

i;L

1

, the expected stock price at t = 1 if investment has been

undertaken and the state is bad. Regardless of whether the speculator is present, the order

‡ow will be A ¸ ¦÷1. 0. 1¦ with uniform probability. If A = ÷1, we have d = : so we exclude

this case. We therefore have:

j

i;L

1

=

1

2

_

1

3

j (0) +

1

3

j (1)

_

1

2

2

3

=

1

2

(j(0) + j(1)) .

This is independent of ` since the presence of the speculator does not change the order ‡ow.

Unlike in the earlier cases of j

L

1

and j

L;spec

1

which did depend on `, here we are conditioning

upon the investment being undertaken. This rules out the case of j (÷1) which is the only price

that depends on `.

48

For part (iia), the short-run return to an investment in the low state is:

j

i;L

1

÷j

0

=

1

2

(j(0) + j(1)) ÷

_

`

6

j(2) +

1

3

j(1) +

1

3

j(0) +

_

1

3

÷

`

6

_

j(÷1)

_

= ÷

`

6

j(2) +

1

6

j(1) +

1

6

j(0) ÷(

1

3

÷

`

6

)j(÷1)

=

1

6

[(1 ÷`)

_

1

i

H

÷1

n

H

_

+ 1

i

L

÷1

n

L

]. (38)

The sign of (38) is the same as the sign of:

(1 ÷`)

_

1

i

H

÷1

n

H

÷(1

n

H

÷1

n

H

)

_

+ 1

i

L

÷1

n

H

÷(1

n

L

÷1

n

H

)

= (1 ÷`)

~

1

i

H

+

~

1

i

L

÷

~

1

n

L

. (39)

Equation (39) is decreasing in `, since

~

1

i

H

0. This implies that

(1 ÷`)

~

1

i

H

+

~

1

i

L

÷

~

1

n

L

< (1 ÷`

min

)

~

1

i

H

+

~

1

i

L

÷

~

1

n

L

= 0.

from equation (34). Thus, equation (38) is negative.

Since j

i;L

1

is independent of `, and j

0

is increasing in ` (because the speculator improves

the manager’s decisions), the absolute return is decreasing in `.

For part (iib), the long-run drift is given by:

1

i

L

÷j

i;L

1

= 1

i

L

÷

1

2

(j(0) + j(1))

= ÷

1

2

(1

i

H

÷1

i

L

) < 0 (40)

and independent of `, since j

i;L

1

is independent of `.

For part (iii), we …rst calculate the di¤erence between the long-run drift and the short-run

return to a good investment, i.e. (37)-(35). This yields:

1

2 + `

(

~

1

i

H

÷

~

1

i

L

) ÷

1

6(2 + `)

[(2 + 2` ÷`

2

)

~

1

i

H

+ (2 ÷2`)

~

1

i

L

÷(2 + `)

~

1

n

L

]

=

1

6(2 + `)

[(4 ÷2` + `

2

)

~

1

i

H

÷(8 ÷2`)

~

1

i

L

+ (2 + `)

~

1

n

L

].

In order to calculate c/: ((37) ÷(35)), we must …rst sign (37)-(35). To prove this is positive,

we must prove that

(4 ÷2` + `

2

)

~

1

i

H

÷(8 ÷2`)

~

1

i

L

+ (2 + `)

~

1

n

L

(41)

is positive. If

~

1

i

L

_ 0, it is automatic that (41) 0. Suppose

~

1

i

L

0. Evaluating (41) at `

min

49

and `

max

, respectively, yields

` = `

min

:(4 ÷2`

min

+ `

2

min

)

~

1

i

H

÷(8 ÷2`

min

)

~

1

i

L

+ (2 + `

min

)[(1 ÷`

min

)

~

1

i

H

+

~

1

i

L

]

= (6 ÷3`

min

)

~

1

i

H

÷(6 ÷3`

min

)

~

1

i

L

0.

` = `

max

:3

~

1

i

H

÷6

~

1

i

L

+ 3

~

1

n

L

0.

If (41) is monotonic in ` in its feasible range, it follows that (41) 0. Suppose that (41) is not

monotonic in `. Then its derivative with respect to ` must have a root `

0

¸ (`

min

. `

max

). The

derivative of (41) is equal to

÷(2 ÷2`)

~

1

i

H

+ 2

~

1

i

L

+

~

1

n

L

.

Then `

0

= 1 ÷

2

~

R

i

L

+

~

R

n

L

2

~

R

i

H

. The condition `

0

`

min

, together with (34), yields

1 ÷

2

~

1

i

L

+

~

1

n

L

2

~

1

i

H

1 ÷

~

1

n

L

÷

~

1

i

L

~

1

i

H

=

2

~

1

i

L

+

~

1

n

L

2

~

1

i

H

<

~

1

n

L

÷

~

1

i

L

~

1

i

H

=4

~

1

i

L

<

~

1

n

L

.

which implies

(41) (4 ÷2` + `

2

)

~

1

i

H

÷(8 ÷2`)

~

1

i

L

+ 4(2 + `)

~

1

i

L

= (4 ÷2` + `

2

)

~

1

i

H

~

1

i

H

+ 6`

~

1

i

L

0 for

~

1

i

L

0.

We now calculate the di¤erence between the long-run drift and the short-run return to a

good investment, i.e. (40) ÷(38). This yields:

÷

1

2

(1

i

H

÷1

i

L

) ÷

1

6

[(1 ÷`)1

i

H

+ 1

i

L

÷1

n

L

]

= ÷

1

6

[(4 ÷`)1

i

H

÷21

i

L

÷1

n

L

].

In order to calculate c/: ((40) ÷(38)), we must …rst sign (40) ÷ (38). To prove this is

negative, we must prove that

(4 ÷`)

~

1

i

H

÷2

~

1

i

L

÷

~

1

n

L

(42)

is positive. At ` = `

max

, equation (42) becomes 3

~

1

i

H

÷2

~

1

i

L

÷

~

1

n

L

0. Since (42) is decreasing

in lambda, we have (42) 0.

Finally, we wish to showthat c/: ((40) ÷(38)) c/: ((37) ÷(35)). The sign of c/: ((40) ÷(38))÷

50

c/: ((37) ÷(35)) is equal to the sign of:

(2 + `)[(4 ÷`)

~

1

i

H

÷2

~

1

i

L

÷

~

1

n

L

] ÷[(4 ÷2` + `

2

)

~

1

i

H

÷(8 ÷2`)

~

1

i

L

+ (2 + `)

~

1

n

L

]

=[(8 + 2` ÷`

2

)

~

1

i

H

÷(4 + 2`)

~

1

i

L

÷(2 + `)

~

1

n

L

] ÷[(4 ÷2` + `

2

)

~

1

i

H

÷(8 ÷2`)

~

1

i

L

+ (2 + `)

~

1

n

L

]

=2(2 + 2` ÷`

2

)

~

1

i

H

+ 4(1 ÷`)

~

1

i

L

÷2(2 + `)

~

1

n

L

. (43)

(43) is quadratic and concave in `. Then its minimum occurs at either `

min

or `

max

. At

` = `

max

, (43) reduces to 6(

~

1

i

H

÷

~

1

n

L

) 0. For ` = `

min

,

(43) = 2(2 + 2`

min

÷`

2

min

)

~

1

i

H

+ 4(1 ÷`

min

)

~

1

i

L

÷2(2 + `

min

)[(1 ÷`

min

)

~

1

i

H

+

~

1

i

L

]

= 6`

min

(

~

1

i

H

÷

~

1

i

L

) 0.

Thus, (43) is always positive, and so c/: ((40) ÷(38)) ÷c/: ((37) (35)).

51

1

Introduction

Whether …nancial markets are informationally e¢ cient is one of the most hotly-contested debates in …nance. Proponents of market e¢ ciency argue that pro…t opportunities in the …nancial market will lead speculators to trade in a way that eliminates any mispricing. For example, if speculators have negative information about a stock, and this information is not re‡ ected in the price, they will …nd it pro…table to sell the stock. This will push down the price, causing it to re‡ speculators’information. However, a sizable literature identi…es various limits ect to arbitrage, which may deter speculators from trading on their information. (This notion of “arbitrage” is broader than the traditional textbook notion of risk-free arbitrage from trading two identical securities. Here, we use “arbitrage” to refer to investors trading on their private information.) For example, De Long, Shleifer, Summers, and Waldmann (1990) and Shleifer and Vishny (1997) show that the slow convergence of price to fundamental value may render arbitrage activities too risky. This in turn dissuades trading if the speculator has a short horizon, which may in turn arise from informational asymmetries with her own investors. Other explanations for limited arbitrage rely on market frictions such as short-sales constraints. All of these mechanisms treat the …rm’ fundamental value as exogenous to the arbitrage process s and rely on market imperfections to explain why speculators will not drive the price towards fundamental value. Thus, as …nancial markets develop, these limits to arbitrage may weaken. In this paper, we identify a quite di¤erent limit to arbitrage, which does not rely on exogenous forces but is instead generated endogenously as part of the arbitrage process. It stems from the fact that the value of the asset being arbitraged is endogenous to the act of exploiting the arbitrage. By trading, speculators cause prices to move, which in turn reveals information to real decision makers, such as managers, board members, corporate raiders, and regulators. These decision makers then take actions based on the information revealed in the price, and these actions change the underlying asset value. This may make the initial trading less pro…table, deterring it from occurring in the …rst place. To …x ideas, consider the following example. Suppose that a …rm (acquirer) announces the acquisition of a target. Also assume that some speculators conducted some analysis suggesting that this acquisition will be value-destructive. Traditional theory suggests that these speculators should sell the acquirer’ stock. However, large-scale selling will convey to the acquirer that s speculators believe the acquisition is a bad idea. As a result, the acquirer may end up cancelling the acquisition. In turn, cancellation of a bad acquisition will boost …rm value, reducing the speculator’ pro…t from her short position and in some cases causing her to su¤er a loss. Put s di¤erently, the acquirer’ decision to cancel the acquisition means that the negative information s possessed by speculators is now less relevant, and hence they should not trade on it. Thus, the information ends up not being re‡ ected in the price. Our mechanism is based on the presence of a feedback e¤ect from the …nancial market to real economic decisions – that real decision makers learn from the market when deciding their actions. A common perception is that managers know more about their own …rms than 2

Electronic copy available at: http://ssrn.com/abstract=1787732

outsiders (e.g. Myers and Majluf (1984)). While this is likely plausible for internal information about the …rm in isolation, optimal managerial decisions also depend on external information (such as market demand for a …rm’ products, or potential synergies with a target) about which s outsiders may be more informed. A classic example of how information from the stock market can shape real decisions is Coca-Cola’ attempted acquisition of Quaker Oats. On November s 20, 2000, the Wall Street Journal reported that Coca-Cola was in talks to acquire Quaker Oats. Shortly thereafter, Coca-Cola con…rmed such discussions. The market reacted negatively, sending Coca-Cola’ shares down 8% on November 20th and 2% on November 21st. Coca-Cola’ s s board rejected the acquisition later on November 21st, potentially due to the negative market reaction. The following day, Coca-Cola’ shares rebounded 8%. Thus, speculators who had s short-sold on the initial merger announcement, based on the belief that the acquisition would destroy value, lost money – precisely the e¤ect modeled by this paper. In the same context, Luo (2005) provides large-sample evidence that acquisitions are more likely to be cancelled if the market reacts negatively to them, and that the e¤ect is more pronounced when the acquirer is more likely to have something to learn from the market, e.g., for non-high-tech deals and where the bidder is small. Relatedly, Edmans, Goldstein, and Jiang (2011) demonstrate that a …rm’ market price a¤ects the likelihood that it becomes a takeover target, which may arise s because potential acquirers learn from the market price. More broadly, Chen, Goldstein, and Jiang (2007) show that the sensitivity of investment to price is higher when the price contains more private information not known to managers. Moreover, our model can apply to corrective actions (i.e., actions that improve …rm value upon learning negative information about …rm prospects) undertaken by stakeholders other than the manager. Such stakeholders likely have less information than the manager and may be more reliant on information held by outsiders. Examples include managerial replacement (undertaken by the board, or by shareholders who lobby the board), a disciplinary takeover (undertaken by an acquirer), or the granting of a subsidy or a bail-out (undertaken by the government). We demonstrate a barrier to the feedback e¤ect, that hinders decision makers from learning from the market. An important aspect of our theory is that it generates asymmetry between trading on positive and negative information. The feedback e¤ect delivers an equilibrium where speculators trade on good news but do not trade on bad news. Yet, it does not give rise to the opposite equilibrium, where speculators trade on bad news only. The intuition is as follows. When speculators trade on information, they improve the e¢ ciency of the …rm’ decisions –regardless s of the direction of their trade. If the speculator has positive information on a …rm’ prospects, s trading on it will reveal to the manager that investment is pro…table. This will in turn cause the …rm to invest more, thus increasing its value. If the speculator has negative information, trading on it will reveal to the manager that investment is unpro…table. This will in turn cause the …rm to invest less, also increasing its value as contraction is the correct decision. When a speculator buys and takes a long position in a …rm, she bene…ts further from increasing its value

3

via the feedback e¤ect. By contrast, when she sells and takes a short position, she loses from increasing the …rm’ value via the feedback e¤ect. Note that, for the speculator to lose from s the feedback e¤ect, she must end up with a short position. If she ends with a long position, the value of the shares she still holds onto are enhanced by the feedback e¤ect. Thus, the model implies that investors are less likely to engage in short-sales than sales –even though the model contains no short-sale constraints. Even though the speculator’ trading behavior is asymmetric, in general it is not automatic s that the impact on prices is asymmetric. The market maker is fully rational and takes into account the fact that the speculator buys on positive information and does not trade on negative information. Thus, he adjusts his pricing function accordingly. Therefore, it may seem that negative information will be impounded in prices to the same degree as positive information – even though it may lead to a neutral rather than negative order ‡ ow, the market maker knows that a neutral order ‡ can stem from the speculator having negative information but ow choosing not to trade, and may decrease the price accordingly. By contrast, we show that the asymmetry in trading behavior does translate into asymmetry in price impact. The crux is that the market maker cannot distinguish the case of a speculator who has negative information but chooses to withhold it, from the case in which the speculator is absent (i.e. there is no information). Thus, a neutral order ‡ does not lead to a large stock price decrease, and so ow negative information has a smaller e¤ect on prices. Indeed, Hong, Lim, and Stein (2000) show empirically that bad news is incorporated in prices more slowly than good news. They speculate that this arises because it is …rm management that possesses value-relevant information, and they will publicize it more enthusiastically for favorable than unfavorable information. Our paper presents a formal model that o¤ers an alternative explanation. Here, key information is held by a …rm’ investors rather than its managers, who “publicize”it not through public news s releases, but by trading on it. They also choose to disseminate good news more readily than bad news, but for a very di¤erent reason from …rm management, i.e., because of the feedback e¤ect. In standard models of underreaction, if bad news has a smaller e¤ect on short-run returns (i.e. between t = 0 and t = 1) than good news, this must be counterbalanced by bad news generating a larger long-run drift (between t = 1 and t = 2) than good news. We show that this need not be the case in a model with feedback. It is indeed true that, if the state is bad and little bad news comes out in the short-run (due to the speculator not trading on it), there is more bad news still to come out in the long-run. However, in a feedback model where …rm value is endogenous, the manager can take a corrective action to mitigate the negative impact of the state on …rm value. If the feedback e¤ect is su¢ ciently strong, bad news has a smaller e¤ect than good news in both the short-run and the long-run. While the above considers the returns to good and bad news, the model also generates predictions regarding the returns to good and bad investment decisions. Naturally, the returns to investment are positive (both in the short-run and long-run) if the state is good and negative

4

if the state is bad. More interestingly, we show that the returns to good investment are more front-loaded than the returns to a bad investment – i.e., a higher proportion of the returns manifests at t = 1 than at t = 2. This result again stems from the asymmetry of the speculator’ s trading strategy. Even if the speculator is aware that the investment is bad at t = 1, she may not trade on this information due to the feedback e¤ect. Thus, the value-destructiveness of the investment seeps out ex post at t = 2. Thus, our model provides an explanation for the negative long-run returns to M&A, documented by Agrawal, Ja¤e, and Mandelker (1992) and Rau and Vermaelen (1998). In addition to its interesting e¤ects on stock returns, the asymmetry of the speculator’ s trading strategy can also generate important real consequences. Since negative information is not incorporated into prices, it does not in‡ uence management decisions. Thus, while positiveNPV projects will be encouraged, some negative-NPV projects will not be canceled – even though there is an agent in the economy who knows with certainty that the project is negativeNPV –leading to overinvestment overall. In contrast to standard overinvestment theories based on the manager’ private bene…ts (e.g., Jensen (1986), Stulz (1990), Zwiebel (1996)), here the s manager is fully aligned with …rm value and there are no agency problems. The manager wishes to maximize …rm value by learning from prices, but is unable to do so since speculators refrain from revealing their information. Applied to M&A as well as organic investment, the theory may explain why M&A appears to be “excessive” and a large fraction of acquisitions destroy value (see, e.g., Andrade, Mitchell, and Sta¤ord (2001).) As mentioned above, the primary motivation for our paper is to identify a limit to arbitrage. Di¤erent authors have emphasized di¤erent factors that lead to limits on arbitrage activities. Campbell and Kyle (1993) focus on fundamental risk, i.e., the risk that …rm fundamentals will change while the arbitrage strategy is being pursued. In their model, such changes are unrelated to speculators’arbitrage activities. De Long, Shleifer, Summers, and Waldmann (1990) argue that noise-trading risk, i.e., the risk that noise trading will increase the degree of mispricing, may render arbitrage activities unpro…table. Noise trading only a¤ects the asset’ market price s and not its fundamental value, which is again exogenous to the act of arbitrage. Shleifer and Vishny (1997) show that, even if an arbitrage strategy is sure to converge in the long-run, the possibility that mispricing may widen in the short-term may deter speculators from trading on it, if they are concerned with redemptions by their own investors. Similarly, Kondor (2009) demonstrates that …nancially-constrained arbitrageurs may stay out of a trade if they believe that it may become more pro…table in the future. Many authors (e.g., Ponti¤ (1996), Mitchell and Pulvino (2001), and Mitchell, Pulvino, and Sta¤ord (2002)) focus on the transaction costs and holding costs that arbitrageurs have to incur while pursuing an arbitrage strategy. Others (Geczy, Musto, and Reed (2002), and Lamont and Thaler (2003)) discuss the importance of short-sales constraints. While these papers emphasize market frictions as the source of limits to arbitrage, our paper shows that limits to arbitrage arise when the market performs its utmost e¢ cient role: guiding the allocation of real resources. Thus, while limits to arbitrage based

5

Section 3 contains the core analysis. 2g. Our paper is related to the literature exploring the theoretical implications of the feedback e¤ects from market prices to real decision making. Section 2 presents the model. here. This paper proceeds as follows. The latter collects In addition. there are no agency problems due to portfolio delegation.on market frictions tend to attenuate with the development of …nancial markets. and Prescott (2010). t 2 f0. and Goldstein. she is informed about the state of nature that determines the pro…tability of continuing vs. demonstrating the asymmetric limit to arbitrage.1 Bond. a limit to arbitrage nevertheless arises because the speculator endogenously chooses not to trade due to the feedback e¤ect. in turn generating implications for the speed of incorporation of news into prices. we will use these two terms interchangeably. managers will learn from them to a greater degree. Overall. Goldstein. Appendix A contains all proofs not in the main text. Most closely related is Goldstein and Guembel (2008). At t = 0. but only with respect to uninformed trading. The manager’ goal is to maximize expected …rm value. In addition to the speculator. and a risk-neutral market maker. 2 The Model The model has three dates. our model is simpler and requires only a single period. while they require two trading periods to generate the asymmetry. such as short-sale constraints. and Yuan (2011) also model complexities arising from the feedback e¤ect. Our model deliberately shuts down the sources of the limits to arbitrage identi…ed by prior theories: the speculator is risk-neutral. Ozdenoren. Section 4 investigates the extent to which information a¤ects beliefs and prices. 1. and Section 6 concludes. Dow. There is a …rm whose stock is traded in the …nancial market. reducing its value by inducing a real decision (investment) based on false information. Their paper also highlights an asymmetry between buy-side and sell-side speculation. who show that it provides an incentive for uninformed speculators to short sell a stock. With all these forces switched o¤. The …rm’ manager needs to take a decision as to whether to continue or abandon an s investment project. the e¤ect identi…ed by this paper may strengthen – as investors become more sophisticated. the point in our paper –that negatively informed speculators will strategically withhold information from the market. we show that informed speculators are less likely to trade on bad news rather than good news. Trading in the …nancial market occurs at t = 1. because they know that the release of negative information will lead managers to …x the underlying problem –is new in this literature. abandoning the project. Goldstein. a risk-neutral speculator may be present in the …nancial market. If present. Section 5 discusses potential applications of the model. since there are no s agency problems between the manager and the …rm. 1 6 . Several papers in this literature have shown that the feedback e¤ect can be harmful for real e¢ ciency. and Guembel (2010). two other types of agents participate in the …nancial market: noise traders whose trades are unrelated to the realization of . and there is no exogenous friction on trading (other than a standard transaction cost).

the dependence of …rm value on the state. we set: i n RH > R H n i RL > R L . the highest …rm value is achieved in state L and we can simply reverse notations. ng.the orders from the speculator and noise traders. consistent with this being labeled as the “high” state. Put di¤erently.. while state L represents low demand. s 2. there is no dominant action). s We assume that whether continuation or abandonment is desirable depends on the state of nature (i. and sets a price at which he executes the orders out of his inventory. all uncertainty is resolved and payo¤s are realized. For example. under the optimal action. no matter what action has been taken by the …rm. state H can represent high demand for the …rm’ products. i. the e¤ect of the state on …rm value. the corrective action attenuates. where d = i represents continuing s the investment and d = n represents no investment (also referred to as “abandonment” or “correction” The …rm faces uncertainty over the realization of value under each possible ). Without loss of generality. action. Whether the …rm continues to invest in s 7 . Abandonment reduces the volatility of …rm value. the manager takes the decision. We denote the …rm’ decision as d 2 fi. We now describe the …rm’ investment problem and the trading process in more detail. We also set: i n RH > R L .1 The Firm’ Decision s Suppose that the …rm has an investment project that can be either continued or abandoned at t = 2.e. continuation is optimal in state H. the reduction in …rm value is lower if the manager has taken action n. there are two possible states 2 fH. which depends on both the state of nature and the manager’ action d. equation (4) incorporates two cases. (3) that is. if the state is L rather than H. while abandonment is optimal in state L. In this case.. which may be a¤ected by the trading in the …nancial market at t = 1. Lg (“high” and “low” We ). In turn. but does not eliminate. Finally.e. At t = 2. (1) (2) that is. state H is better for …rm value. This assumption is also without loss of generality as. In particular. if it is not satis…ed. Note that equations (1) and (2) imply: i RH i n RL > R H n RL : (4) Equation (4) is the driving force behind our results. the highest …rm value is achieved in state H. Hence. depending on whether …rm value is monotonic in the underlying state: n n Case 1: RH > RL . It means that taking the corrective action reduces the negative e¤ect of state L on …rm value. d denote the value of the …rm realized in t = 2 as v = R .

she observes the state of nature with certainty. the case RL > RH implies non-monotonicity of …rm value in the state: one state does not dominate the other. and state L refers to the reverse.. Since the prior y is 1 . and d = n corresponds to a strategy focused on current pro…t margins.e. n n Case 2: RL > RH . a speculator arrives in the …nancial market. The second case is where > 1 . the investment has a positive net present value. the corrective action is su¢ ciently powerful to overturn the e¤ect of the state on …rm value. 2 2. and so the ex-ante net present value of the investment is negative. Another example is related to Aghion and Stein (2008): d = i corresponds to a growth strategy. Growth prospects are good if = H and bad if = L. Chakraborty and Yilmaz (2004) also feature uncertainty on whether the speculator is present. since in the high state. s he will continue the project. with probability 0 < < 1. which is common knowledge. Put di¤erently. consider the case where continuation implies proceeding with a takeover decision.2 Trade in the Financial Market In t = 0.e. We will use the term “positively-informed speculator” to Since private information is not public knowledge. in turn worsening its competitive position.: i RH + (1 i n )RL = RH + (1 n )RL : (5) The value of represents a “cuto¤”that determines the manager’ action. its existence is also unlikely to be public knowledge. We use q to denote the posterior probability the manager assigns to the case = H. in an equilibrium in which informed insiders manupulate the market by trading in the wrong direction. The …rst case is where < 1 . i. the manager would continue the investment without further 2 2 information. and abandonment implies keeping the cash for future opportunities. its value is higher in state L where future acquisition opportunities are superior. The manager’ s decision is conditioned on q. If and only if q > . Importantly. its rivals could pursue the growth opportunities. i. 2 8 . Under continuation. but the negative e¤ect of state L is attenuated if the …rm does not invest. whereas if the …rm chooses to postpone acquisitions.2 If the speculator is present. …rm value is higher in state H. this second case does not require that abandonment reduces n n i i the volatility of …rm value: it could be that abs (RH RL ) > abs (RH RL ) so volatility is n n higher under correction. We will distinguish between two cases. In this case. Whether the speculator is present or not is unknown to anyone else. if the corrective action is taken. Instead. For example. ex ante. …rm value is higher in state L.its production process or not. 1 The prior probability that the state is = H is y = 2 . If the …rm eschews the growth strategy (d = n). which in turn is calculated using information arising from trades in the …nancial market. its value will be lower in state L. Let denote the posterior belief that the state is H such that the manager is indi¤erent between continuation and abandonment. State H corresponds to a state in which current acquisition opportunities dominate future ones. its value is higher in the low state where there are no growth opportunities.

Under the ow alternative assumption that the manager observes p. and uses the information in X to form ow his posterior q. where the price is essentially uninformative. rather than just the price p. 1g that maximizes his expected …nal payo¤ s(v p) jsj . we assume that she will not trade. 2. A critical departure from Kyle (1985) is that …rm value here is endogenous. orders are submitted simultaneously to a market maker who sets the price and absorbs order ‡ ows out of his inventory. who trades z = 1. it is de…ned as follows: (i) A trading strategy by the speculator: S : ! f 1. and his information about the realization of . 1. second. there is a one-to-one correspondence between the price and the order ‡ so it does not matter which variable the manager observes. we do not analyze such equilibria here. Trading either 1 or 1 is costly for the speculator and entails paying a cost of . The orders are market orders and are not contingent on the price. Possible order ‡ ow ows are X 2 f 2. or 1 with equal probabilities. which is then used in the investment decision. It is also realistic to assume that managers have access to information about trading quantities in the …nancial market: …rst. microstructure databases (such as TAQ) provide such information at a short lag –rapidly enough to guide investment decisions. which requires the price to be informative. equilibria can arise. the strategy of the manager. Moreover. 2g). and “negatively-informed speculator”to describe a speculator who observes = L. because the manager’ action is based on s information revealed during the trading process. The competitive market maker sets the price equal to expected asset value. Speci…cally. (iv) the …rm and the market maker use Bayes’ 9 . market making is competitive and so there is little secrecy in the order ‡ ow. Allowing the manager to observe order ‡ X. Here. we refer to trading pro…ts and losses gross of the cost . 1. she makes an endogenous trading choice s 2 f 1. other. 0. ng (where Q = f 2. The market maker can only observe total order ‡ X = s + z. given the information contained in the order ‡ ow. 0. given the information in the price and all other strategies. (iii) A price setting strategy by the ow market maker p : Q ! R that allows him to break even in expectation. Unless otherwise speci…ed. If the speculator is present. but not its individual components s and z. Following Kyle (1985). that maximizes expected …rm value v = Rd given the information in the order ‡ and all other strategies. 0. In the equilibria that we analyze. (ii) An investment strategy by the …rm D : Q ! fi. simpli…es the analysis without a¤ecting its economic ow content.describe a speculator who observes = H. 0. 1. Since this paper’ focus is to analyze the feedback s e¤ect. The variable is a measure of market sophistication or the informedness of outside investors and will generate a number of comparative statics. If the speculator is indi¤erent between trading and not trading (because her expected pro…ts from trading exactly equal ). 1.3 Equilibrium The equilibrium concept we use is the Perfect Bayesian Nash Equilibrium. 1g. given the price setting rule. 2g and the pricing function is p (X) = E(vjX). non-interesting. Always present is a noise trader. 0. Trading in the …nancial market happens in t = 1. the manager observes total order ‡ X.

n RL ) . i RL and n (RH n RL ) > 0: (9) (10) 2 1 = 11 32 i RH The results also depend on whether order ‡ is su¢ ciently informative to overturn the decision ow to invest. In 2 our characterization. Finally. While X = 2 is also a negative order ‡ ow. Hence. there is no feedback e¤ect for X = 1. (vi) all agents have rational expectations in that each player’ belief s about the other players’strategies is correct in equilibrium. i. the quantity 1 is relevant as. in some equilibria. 3. 3 10 . the …rm’ decision in this case is not relevant for equilibrium s trading strategies as the speculator’ information is fully revealed and so she never makes a pro…t. We consider Case 1 (RH > RL ) …rst and then s n n proceed to Case 2 (RH < RL ). a negative order of X = 1 is not su¢ ciently informative to lead the manager to abandon the default plan of investing. and (v) beliefs on outcomes not observed on the equilibrium path satisfy the Cho and Kreps (1987) intuitive criterion. where R 3 H 1 n (RH i RL . it represents the posterior probability of state H under 2 1 an order ‡ of X = 1.rule in order to update their beliefs from the order they observe in the …nancial market. Here. which is the ex-ante optimal decision. Here. we make use of three di¤erent threshold levels of the cost of trading : 1 2 3 1 1 i 1 i RH RL + 3 2 2 1 1 1 i + RH 3 2 2 1 i i RL . The …rst case is 2 < . we will show that our main insight carries through to the case where > 1 . the probability that the speculator ow is present is su¢ ciently high that a negative order of X = 1 is su¢ ciently informative to deter the manager from investing. we distinguish between two cases 1 depending on whether the cuto¤ is higher or lower than 2 . Later. the …rm will choose to invest. Thus. this s node is not relevant for determining the equilibrium trading strategies.1 n n Case 1: Firm Value is Monotone in the State: RH > RL 1 We start with the case where < 2 .e. Thus. Thus. without further information. We demonstrate the emergence of asymmetric limits to arbitrage as a result of the feedback from market trading n n outcomes to the …rm’ investment decision. As we will show.. (6) (7) (8) < 2 < 3. there is feedback from the market to real decisions for 1 the case of X = 1. 2 > . 3 Feedback E¤ect and Asymmetric Limits to Arbitrage In this section. we characterize the pure-strategy equilibria in our model.3 Second.

the only pure-strategy equilibrium is 2 1 BN S. depending on the values of . there is a strictly positive range of parameter values ( 1 < 2 ) for which the BN S equilibrium exists but the SN B equilibrium does not exist. the manager’ decision d and the price p are given ow s by the following table (see Appendix A for the full calculations): X q d p 2 0 n n RL 1 2 1 i 1 i R 2 H i + 1 RL 2 0 1 2 1 1 2 i 1 i R 2 H i + 1 RL 2 i 1 i R 2 H i + 1 RL 2 2 1 i i RH 11 . the only possible pure-strategy equilibria are N T . Below. in the case of no feedback ( 2 > ).Not Sell): the speculator buys when she knows that = H and does not trade when she knows that = L. there are two pure-strategy equilibria: BN S and SN B. the only pure-strategy equilibrium is N T . if and only if there is feedback ( 2 < ). There is no range of parameter values for which the SN B equilibrium exists but the BN S equilibrium does not exist. Partial Trade Equilibrium BN S (Buy . No Trade Equilibrium N T : the speculator does not trade. and SN B. When 2 < 3 . If an order ‡ of X = 2 (X = 2) is observed o¤ the equilibrium path. = H and sells when 3. Then. this is the only belief that is consistent with the intuitive criterion. T . Given that …rm value is always higher when = H than when = L. Then the trading game has the following pure-strategy 2 equilibria: When < 1 . 2. 1 That is. Suppose that RH > RL and < 1 . BN S. Partial Trade Equilibrium SN B (Sell . investment is ex-ante desirn n able). Given that speculators always lose if they trade against their information. four equilibrium outcomes can arise: 1. the only pure-strategy equilibrium is T . the beliefs ow of the market maker and the manager are that the speculator knows that the state is L (H). the posterior q. 4. the only pure-strategy equilibrium is T . Proposition 1 (Equilibrium.Not Buy): the speculator does not trade when she knows that = H and sells when she knows that = L. Proof.As we show. Proposition 1 provides the characterization of equilibrium outcomes. When 3 . When 1 < 2 : in the case of feedback ( 1 < ). Trade Equilibrium T : the speculator buys when she knows that she knows that = L. No Trade Equilibrium N T : For a given order ‡ X. it is straightforward to show that the speculator will never buy when she knows that = L and will never sell when she knows that = H. …rm value is monotone in the state. we identify the conditions under which each one of these equilibria holds.

Partial Trade Equilibrium BN S: For a given order ‡ X. the posterior q. the manager’ decision d and the price p are given ow s by the following table: X q d p 2 0 n n RL 1 2 1 i 1 i R 2 H 1 i + 2 RL 0 1 2 1 1 2 i 1 i R 2 H 1 i + 2 RL i 1 2 i RH + 1 2 i RL 2 1 i i RH Calculating the pro…t for the negatively-informed speculator from deviating to not trading and for the positively-informed speculator from deviating to buying. we can see that this equilibrium holds if and only if 2 < 3. the posterior q. we can see that this equilibrium holds if and only if 2 < 3 for the case of no feedback ( 1 > ) and if and only 2 if 1 < 3 for the case of feedback ( 1 < ). 2 Trade Equilibrium T : For a given order ‡ X. Partial Trade Equilibrium SN B: For a given order ‡ X. this equilibrium holds if and only if 3.As shown in Appendix A. Thus. the pro…t for the negatively-informed speculator from deviating i i to selling is 1 (RH RL ). and this is also the pro…t for the positively-informed speculator from 3 deviating to buying. the manager’ decision d and the price p are given ow s by the following table: X q d p 2 0 n n RL 1 1 2 ( 0 1 2 1 2 1 2 2 1 2 1 1 2 2 1 i i + 1 RL 2 i RH ( n if i if 1 2 1 2 < > 1 n RL i RL i if if 1 2 1 2 i i + 1 RL 2 1 i R 2 H n RH + i RH + < > 1 i R 2 H Calculating the pro…t for the negatively-informed speculator from deviating to selling and for the positively-informed speculator from deviating to not trading. the posterior q. the manager’ decision d and the price p are given ow s by the following table: X q d p 2 0 n n RL 1 1 2 ( 0 1 2 1 2 1 2 2 1 2 1 1 2 2 1 i ( n if i if 1 2 1 2 < > 1 n RL i RL i if if 1 2 1 2 i 1 i + 2 RL 1 2 i RH + 1 2 i RL n RH + i RH + < > 12 1 i R 2 H i RH .

To understand the various forces. the only pure-strategy equilibrium entails no trade at all by the speculator.Calculating the pro…t for the negatively-informed speculator from deviating to not trading and for the positively-informed speculator from deviating to not trading. the only pure-strategy equilibrium is one where the speculator always trades on her information. in both partial trade equilibria. When < 2 . Thus. Thus. a negative order ‡ is very revealing that the speculator is negatively informed and the price ow moves sharply to re‡ this. both of which are common in the literature. but ow not su¢ ciently negative to deter the manager from abandoning the default plan of investing. 1 Thus. Thus. There is symmetry in that both types of asymmetric equilibria are possible in exactly the same range of parameters. one of which is the feedback e¤ect that is the focus of our paper. X = 1 is inconsistent with the speculator having ect 1 i i positive information. i. there are equilibria where the speculator trades on one type of information but not the other. there are three regions of the parameter . Thus.. the market maker sets a relatively low price of 1 RH + 1 RL . From (4) and (10). a positive order ‡ is consistent with the speculator being negatively informed: ow X = 1 is consistent with the noise trader buying. The second source is the price impact that speculators exert when they trade on their information. In sum. and one in which she sells on bad news but does not trade on good news. 1 < 2 requires < 1. In this case. As increases. which always holds. The …rst source is the trading cost . and so the speculator only receives 2 RH + 2 1 RL from selling. Proposition 1 demonstrates the sources of limits to arbitrage in our model. Clearly. we start 1 by describing the equilibrium outcomes in the case of no feedback. In the intermediate region 2 < 3 . there are two pure strategy equilibria. knowing this. there is a range of for which the only equilibrium is BN S if 1 < 2 and 2 < .e. In turn. When 3 . the order ‡ in the direction in which the speculator ow does not trade becomes particularly informative. and the speculator being negatively informed i i and choosing not to trade. when 2 > . Speci…cally. the speculator makes little pro…t from selling on bad news. given that the market maker believes that the speculator does not sell on bad news. To understand the intuition behind these asymmetric equilibria. they have lower incentives to trade. 1 < requires > 11 2 . consider the BN S equilibrium without feedback (the case of the SN B equilibrium is analogous). we move to equilibria where speculators trade less on their information. Two sources of limits to arbitrage are present in the no-feedback case. Conversely. there 2 exist values of that satisfy both of the above conditions if 11 2 < 1. When 2 < 3. an order ‡ of X = 1 may convey (depending on the equilibrium) negative information. the equilibrium is sustainable. she chooses not to trade on bad news. when speculators are subject to greater transaction costs. one in which the speculator buys on good news but does not trade on bad news. we can see that this equilibrium holds if and only if < 2 for the case of no feedback ( 1 > ) and if and only if 2 1 < 1 for the case of feedback ( 2 < ). Here. 2 2 which allows the speculator to make high pro…ts by buying. leading to larger price impact which reduces 13 . exhibiting limited trade. Given that the market maker believes that the speculator buys on good news.

A high trading cost leads to the N T equilibrium where there is no trading in either direction. this augments …rm value. if > 1 . and so positive news 2 from the market does not change his decision and does not a¤ect …rm value. thus. Unlike trading costs and price impact. On the other hand. 1 In particular. if > 2 ). the feedback e¤ect leads to an asymmetric limit to arbitrage that deters selling on bad news but not buying on good news. By contrast. i. the Trade Equilibrium T is replaced with the Partial Trade Equilibrium BN S. which (weakly) causes him to increase investment. she may lead the manager to abandon a bad investment. Buying on good news may reveal to the manager that the state is good. the two limits to arbitrage studied in prior research are symmetric. when the speculator sells on bad news. the feedback e¤ect does not deter the positively-informed speculator from buying on good news. By n i that. Since she is holding a short position. Hence. In the case of feedback. trading on her information in either direction – whether it is buying on positive information or selling on negative information – conveys information to the manager. 1 We now move to the case of feedback.. since RL > RL . Indeed. without feedback (i. she improves …rm value. This force is symmetric in the absence of feedback. Our main result is that the feedback e¤ect introduces an additional limit to arbitrage that is distinct from those identi…ed in prior literature – arbitrage is limited because the value of the asset being arbitraged is endogenous to the act of arbitrage. Hence we state that buying on good information causes the manager to weakly increase investment. there is no value of in which there is one In the case discussed so far ( < 1 ) the default option for the manager is to invest.e. BN S and SN B.e. the di¤erence between equilibrium outcomes in the two cases of no-feedback and feedback is that in the range 1 < 2 . it deters the speculator from selling on bad news. 2 4 14 . there is no range of parameters where the SN B equilibrium exists but the BN S equilibrium does not exist. since investment is desirable in the high state. Hence. not trading in this direction is sustained in equilibrium. Thus. buying on 2 good news causes the manager to strictly increase investment. The intuition behind the asymmetry of our e¤ect is as follows. Here. This reduced pro…t a¤ects the speculator’ equilibrium trading strategy s and causes her not to sell on bad news if 1 . This improves his decision making and thus fundamental …rm value. but there is symmetry in that both equilibria are possible in exactly the same range of parameters. Increased …rm value augments the pro…tability of a long position but reduces the pro…tability of a short position.4 Overall. However. Abandonment is the optimal decision in state L. which will further increase her incentive to trade. the limit to arbitrage arising from the feedback e¤ect is asymmetric: it reduces the extent of selling on bad news but not the extent of buying on good news. when 2 < . improving the manager’ decision reduces the s 1 i i speculator’ pro…t in the node of X = 1 from 2 (RH RL ) (in the case of no-feedback) to s 1 n n only 2 (RH RL ). an order ‡ of X = 1 ow provides enough negative information for the manager to abandon the investment.. As we will show later. this increase in …rm value reduces her pro…t. This e¤ect is the driving force behind our results in the case of > 1 .the potential trading pro…ts. Price impact leads to the two partial trade equilibria. in turn strictly improving …rm value. The speculator will then pro…t from the increase in the value of her long position.

To see this. then 1 = 2 and there is no range of parameter values in which there is a BN S equilibrium only.. Because the speculator knows both the manager’ 1 d d action and the state is L. Thus. the manager’ action d (and thus the feedback e¤ect on the manager’ action) matters for the s s speculator’ trading pro…ts. If = 1. since the state has a lower e¤ect on …rm value under correction. BN S and SN B equilibria occur over the same range of parameters. Intuition may suggest that the market maker’ pricing function can “undo” the feedback e¤ect: the market s maker is fully rational and takes into account the fact that the order ‡ will a¤ect the manow ager’ decision.e. or the speculator being present and negatively informed. whereas with feedback. The source of her pro…t is her superior information on the state. and that the state is L. the BN S equilibrium occurs over a wider range than the SN B equilibrium. The next proposition shows that when > 1 . the speculator is not always present. In turn. when the 2 2 default decision is abandonment. since he is competitive. he sets a price that re‡ s ects this decision. since positive order ‡ leads ow to investment but the investment would be undertaken in the absence of further information anyway. consider the market maker’ inference from seeing X = 1 in the BN S equilibrium. but superior knowledge of the state. Here. superior knowledge of the state results from fact that < 1. The key to our result is that the source of the speculator’ pro…ts is s not superior knowledge of the manager’ action (since the action is always perfectly predicted s by the market maker). Thus. the speculator makes zero pro…t. and so the market maker knows for certain that = L. the market maker predicts the manager’ s action but does not know the state. i.partial trade equilibrium but not the other. By contrast. Indeed. Such intuition turns out to be incorrect. i. if = 1. This order ‡ is s ow consistent with either the speculator being absent (in which case the state may be H or L). and n so sets price exactly equal to the fundamental value of RL . Put di¤erently. her pro…ts are lower in this case. We now wish to verify that the asymmetry between buy-side speculation and sell-side speculation. which in turn depends on the decision d. the case < 1 . Since X = 1 can be consistent with the speculator being absent and the state being H.e. The reason for why the feedback e¤ect reduces trading pro…ts is nuanced. i. if < 1. the order ‡ of X = 1 is fully ow revealing: the market maker knows both that correction will occur. but because the action a¤ects the value of the speculator’ superior s s knowledge on the state.. the source is that the feedback e¤ect increases the pro…tability of a long position 15 . In the case of < 1 . the 2 source of the limit to arbitrage was that the feedback e¤ect reduces the pro…tability of a short position but does not a¤ect the pro…tability of a long position. our results are qualitatively similar: without feedback. is not an artifact of the fact that investment is the default decision. she makes a pro…t of 2 RH RL . driven by the feedback e¤ect. it may seem that the action does not matter. Because the price that the speculator receives from selling will always re‡ the action taken by the manager ect (be it continuation or investment).e. the …rst case is ruled out. not because the speculator’ pro…ts stem from superior knowledge s s of the manager’ action. the market maker allows for the possibility that the state may 1 d d s be H and sets a price of 2 RH + 2 1 RL .

if 01 < 03 . and is thus omitted for brevity. In both cases (for both < 2 and > 1 ). 2 1 represents the posterior probability of state H if X = 1. Suppose that RH > RL and > 1 . i RL . the role of the feedback e¤ect can be seen in the BN S equilibrium: 2 it reduces the pro…ts that the negatively-informed speculator would earn by deviating and selling. the only pure-strategy equilibrium is N T . 0 When 3 . …rm value is monotone in the state. there are two pure-strategy equilibria. an order ‡ of X = 1 is not informative enough to lead the manager to invest. There is no range of parameter values for which the SN B equilibrium exists but the BN S equilibrium does not exist. the 2 intuition is the same: the feedback e¤ect (weakly) increases the pro…tability of a long position and (weakly) decreases the pro…tability of short position. (11) (12) (13) (14) The cuto¤ for feedback e¤ect to exist is also adjusted here. this range is 02 < 03 . and so the BN S equilibrium is sustainable over a wider range of parameters than the 16 . and 3 < 03 . de…ne new threshold levels of the cost of trading : 0 1 0 2 0 3 0 2 1 1 1 n n (RH RL ) + 3 2 2 1 1 1 n + (RH 3 2 2 1 n n (RH RL ) . Proof. Hence. The following proposition provides the characterization of equilibrium outcomes. since abandonment would be undertaken 1 in the absence of further information anyway. If 2 1 < . Proposition 2 (Equilibrium. as discussed above. In the case of < 1 . The proof repeats similar steps to those in the proof of Proposition 1. BN S and SN B. in the case of feedback ( 2 1 > ). the only pure-strategy equilibrium is T . 02 < 01 i RH n RL ) .but does not a¤ect the pro…tability of a short position. there is a range of parameter values for which the BN S equilibrium exists but the SN B equilibrium does not exist. whereas the SN B equilibrium exists only in the sub-range 01 < 03 or does not exist (if 01 > 03 ). In some equilibria. That is. investment is ex-ante unden n sirable). ow This is the case where there is no feedback. If 2 1 > . When 02 < 03 : in the case of no feedback ( 2 1 < ). if and only if there is feedback ( 2 1 > ). the probability that the speculator is present is su¢ ciently high that an order ‡ of X = 1 contains enough information to lead the ow manager to invest (as opposed to the default option of abandoning). For this proposition. the BN S equilibrium always exists. there is feedback. this range is 02 < 01 . If 01 > 03 . then the trading game has the following pure-strategy 2 equilibria: When < 02 .

Hence. if 01 > 03 . i i will be between RL and RH . 2 Since buying improves the …rm’ fundamental value. 3. In both cases (for < 2 and > 1 ). however. investment will occur. since …rm value is always higher in state H than in state L. or not trade). The analysis of equilibrium outcomes becomes more complicated in the case of non-monotonicity.2 n n Case 2: Firm Value is Non-Monotone in the State: RH < RL In this subsection. (ii) The trading game has no pure-strategy equilibrium where the speculator buys when she knows that = L. Proof. now that …rm value may be higher in state L.. then X 2 f 2. In each one of these nodes. sell.e. and so the speculator makes a loss from selling. Here. its value is higher n n in state = L (RH < RL ). since < 2 . i. The following lemma simpli…es the equilibrium analysis. there are nine possible pure-strategy equilibria (each type of speculator –positively-informed and negatively-informed –may either buy. Given that the positively-informed speculator does not sell. (ii) Suppose that the speculator buys when she knows that = L. without further information. and so …rm value is RL .SN B equilibrium. the feedback e¤ect impacts the SN B equilibrium. 1. We start by characterizing equilibrium outcomes for the case where < 1 . where > 1 . where …rm value is monotone in the state. However. Hence. leading to the BN S equilibrium being sustainable over a wider range of transactions costs than the SN B equilibrium. 2 the …rm will choose to invest. 0g. a positively-informed speculator always loses money by selling and a negatively-informed speculator always loses money by buying. if the …rm does not invest. a positively-informed speculator may …nd it optimal to sell and a negatively-informed speculator may …nd it optimal to buy. The price. posterior probability q of state H is at least 1 (given that these 2 nodes are consistent with the action of the positively-informed speculator and may or may not be consistent with the action of the negatively-informed speculator. 1g. and so the SN B equilibrium is sustainable over a narrower range of parameters than the BN S equilibrium 1 (indeed. and so …rm value is RH . the posterior probability q is 1 at 2 1 i X 2 f0. moving us closer to the analysis conducted in the previous subsection. the feedback e¤ect increases the pro…t s that the positively-informed speculator would earn by deviating and buying. 2g. the corrective action is su¢ ciently powerful to outweigh the e¤ect of the state on …rm value and lead to a higher value in the low state. depending on her equilibrium 1 i action). investment will occur. (i) Suppose that the speculator sells when she knows that = H. Hence. the end 2 result is the same: the feedback e¤ect increases the pro…ts from informed buying and reduces the pro…ts from informed selling. In the previous subsection. then X 2 f0. Then. then: 2 (i) The trading game has no pure-strategy equilibrium where the speculator sells when she knows that = H. Since the price 17 . n n Lemma 1 Suppose that RH < RL and < 1 . since < 2 . it is not sustainable at all). we consider the case where. 1.

and BN S. We nevertheless retain this assumption regarding o¤-equilibrium beliefs. while an o¤-equilibrium order ‡ of X = 2 is due to the negatively-informed speculator (and so the posterior is ow q = 0). there are four possible pure-strategy equilibria. If she does not trade in equilibrium. Interestingly. buying a security worth RL for a price of RL . If the positively-informed speculator buys in equilibrium. but because the speculator has a long position. there are two 2 2 possibilities. The reason that the positively-informed speculator never sells in equilibrium is that if the market maker and the manager believe that she sells. Then. Hence. In Case 1. due to monotonicity. another issue that arises in this subsection is the speci…cation of o¤-equilibrium beliefs. Since abandonment is suboptimal if = H. Again. T . Thus. Proposition 3 (Equilibrium. When X = 2. Goldstein and Guembel (2008) also derive conditions to ensure that the speculator does not deviate from the equilibrium to trade against her information. she potentially misleads the market maker and the manager to think that the negatively-informed speculator is present. Suppose that RH < RL and < 1 . The following proposition provides the characterization of equilibrium outcomes. the only assumption that satis…ed the intuitive criterion was that an o¤-equilibrium order ‡ of X = 2 is due ow to the positively-informed speculator (and so the posterior is q = 1). and suppose that the belief of the market 2 maker and the manager is that an o¤-equilibrium order ‡ow of X = 2 (X = 2) is associated i (Ri RL ) with the presence of negatively-informed (positively-informed) speculator. in expectation she makes a loss. investment is ex-ante n n desirable). this causes her to make a loss. SN B. the conditions for these equilibria to hold are now tighter. this reduces …rm value. she cannot make a pro…t from selling. an additional condition must be satis…ed to ensure that the positively-informed speculator does not have an incentive to deviate to selling. the same issue does not arise with the negatively-informed speculator. as she never has an incentive to deviate to buying. and so to (incorrectly) take the investment. Our results remain the same for any other o¤-equilibrium beliefs that are monotone in the order ‡ ow. which is reasonable given the possible equilibria in our model.5 In analyzing deviations from the equilibrium. then the negatively-informed n n speculator is revealed. then the outcome is the same as on the other nodes. just as in the previous subsection: N T . However. the characterization of equilibrium outcomes is identical to that in Proposition 1. the intuitive criterion is not su¢ cient to rule out other o¤-equilibrium beliefs. In this subsection. 5 18 . she still might be tempted to deviate to selling in any of the four equilibria mentioned above. However. this decision reduces …rm value and causes the speculator to make a pro…t on her short position. however. given she loses at X 2 f0. for any of the above four equilibria to hold. 1g. …rm value is non-monotone in the state. Following the lemma. if RH Rn is n ( L H) su¢ ciently high. the speculator will lose money on these nodes. she misleads the market maker and the manager to think that the positively-informed speculator is present. and so to abandon the investment. If she does so.i i is 1 RH + 1 RL . When she sells.

the key to this result is < 1. in which correction not only mitigates the e¤ect of the low state but also overturns it. and that correction is desirable n for …rm value (since she knows that = L). Analyzing the possible trading pro…ts for the negatively-informed speculator from deviating to buying in each of the four possible equilibria. ( L H) Proof. this force is even stronger because the range of transaction costs between 1 and 2 . but not the positively-informed speculator. 6 3 RH Rn > 1. 33 2 RH Rn > 1.More speci…cally. the following additional conditions are required for the various equilibria to hold: i i n n Equilibrium N T and SN B: > 1 ( (RH RL ) + (RL RH )). the conditions for the positively-informed speculator to choose between buying and not trading and for the negatively-informed speculator to choose between selling and not trading are identical to those derived in the proof of Proposition 1. In contrast. The speculator knows that the corrective action will be taken. 2 Rn Rn > 1. Hence. 4 2 ( L H) i (Ri RL ) Equilibrium T : in the case of feedback ( 1 < ). the market maker knows the corrective action will be taken but is not certain that correction is desirable for …rm value. In this subsection. in which the BN S equilibrium exists due to feedback but the n n SN B equilibrium does not exist. 3 i (Ri RL ) 1 Equilibrium BN S: in the case of feedback ( 2 < ). the feedback e¤ect deters the negatively-informed speculator. The calculations of the posterior q. exists also in the case where RH < RL . n ( L H) As the proposition demonstrates. again. implies that the negatively-informed speculator can make a loss –even before transaction costs –when selling on bad news. This result is in contrast to standard informed trading models where a speculator can never make a loss (before transactions costs) if she trades in the direction of her information. from trading on her information. the main force identi…ed in the previous subsection for the n n n n case where RH > RL . but also with an absent speculator and selling by noise traders. because she is unsure of the underlying state . Hence. Even though both the speculator and market maker know that abandonment will occur if X = 1. is higher when (RH RL ) is negative: see equation (10). it is straightforward to see that she always loses from buying and hence will never deviate. This loss occurs at the X = 1 node. Order ‡ X = 1 is consistent ow with a negatively-informed speculator. These conditions are i (Ri RL ) binding only when RH Rn is not su¢ ciently high. in which case the manager’ corrective action is s 19 . they have di¤ering views on …rm value conditional on abandonment. A strong feedback e¤ect. Appendix A calculates the possible trading pro…ts for the positivelyinformed speculator from deviating to selling in each of the four possible equilibria. the manager’ decision d and the price p for di¤erent s order ‡ ows X in the various possible equilibria are identical to those provided in the proof of Proposition 1. in the case of no 6 2 ( n L H) i i (RH RL ) 1 feedback ( 2 > ). which yields obtain the additional conditions stated in the body of the proposition. That is. in the case of no n 2 ( L H) i i (RH RL ) 1 feedback ( 2 > ). 8 3 Rn Rn > 1. it is possible that = H. and so …rm value is RL .

Partial Trade Equilibrium SN B 0 (Sell . the speculator now sells if = H and buys if = L. In this case. Hence. 4. = H represents bad news and = L 2 represents good news. there are additional conditions for the various possible equilibria. The next lemma is the mirror image of Lemma 1: n n Lemma 2 Suppose that RH < RL and > 1 . Therefore. Thus. The proof is symmetric to the proof of Lemma 1 and hence is not repeated here. making it relatively more di¢ cult to obtain the BN S equilibrium due to feedback. we analyze the case where > 2 . Trade Equilibrium T 0 : the speculator buys when she knows that she knows that = H. leading to …rm value of RH . the possible pure-strategy equilibria here are: 1. This is the desire of the positively-informed speculator to deviate from her equilibrium behavior and manipulate the price by selling. e¤ectively. …rm value is lower in state H than in state L. 2. Otherwise. even though she has good news. (ii) The trading game has no pure-strategy equilibrium where the speculator buys when she knows that = H. The characterization of equilibrium outcomes in the following proposition is symmetric to that in Proposition 3: 20 . However. Proof. then: 2 (i) The trading game has no pure-strategy equilibrium where the speculator sells when she knows that = L. She can potentially pro…t from leading the manager to take the wrong decision. the proposition also shows that another force that arises from the feedback e¤ect exists in this subsection.n undesirable. It turns out that this case is the exact mirror image of the case where < 1 . The manipulation incentive is not strong enough to interfere i (Ri RL ) with equilibrium conditions as long as RH Rn is su¢ ciently high. which enables her to pro…t from her short position. = L and sells when 3.Not Buy): the speculator does not trade when she knows that = L and sells when she knows that = H. 1 Finally. No Trade Equilibrium N T : the speculator does not trade. Now. Partial Trade Equilibrium BN S 0 (Buy . the price set by the market maker is only 1 n n RH + 2 1 RL . and so 2 1 n n the speculator loses 2 (RH RL ) before transaction costs.Not Sell): the speculator buys when she knows that = L and does not trade when she knows that = H. the loss from n ( L H) i i trading against good news (which is proportional to (RH RL )) is high relative to the benen n …t from manipulation (which is proportional to (RL RH )). This is because the default decision is to abandon the investment. under this decision. and that this force has implications on the characterization of equilibrium outcomes. since he puts weight on the fact that correction may be undesirable.

BN S 0 . RL . and so the SN B is sustainable over a narrower n n range of parameters. …rm value is non-monotone in the state. To see this. Due to feedback. RL are replaced with n n i i parameters RL . respectively. the trading in the market has to contain su¢ cient information to in‡ uence the manager’ decision. i. In the current scenario of > 1 within Case 2 (RH < RL ). Several assumptions play a key role in generating this result. 3. Proof. Then. 2 < is more likely to be satis…ed the closer is to 1 . since they demonstrate the conditions under which the asymmetric limit to arbitrage will exist. it is important that the probability that the speculator is present is 2 su¢ ciently high so that the order ‡ is su¢ ciently informative to change managerial decisions. for the sub-case of > 2 . If is very low. When is close to 2 . These assumptions in turn lead to empirical predictions.3 Summary and Discussion of Assumptions The above analysis has shown that the presence of feedback from market trading to …rms’ decisions creates a wedge between buy-side speculation and sell-side speculation. consider again the result in Proposition 21 . the ex-ante NPV of the project is so high that the manager will almost always undertake the investment. RH . Hence. so there is uncertainty on whether there is an informed speculator in the market. the closer the NPV of the 2 1 project is to 0. The proof is symmetric to the proof of Proposition 3 and hence is not repeated here. respectively. and equilibria T . the role of the feedback e¤ect is seen in the 2 BN S/BN S 0 equilibrium: it deters the speculator from deviating to sell on bad news ( = H in this case). For example. SN B 0 . consider the result in Proposition 1: for the wedge to arise. RL . the characterization of equilibrium i i n n outcomes is symmetric to that in Proposition 3: parameters RH . we s require 1 < . the desirability of the investment is su¢ ciently uncertain that the manager’ decision will be in‡ s uenced by the trading in the …nancial market. discouraging speculators from selling on bad news. SN B are replaced with equilibria T 0 . and suppose that the belief of the market maker 2 and the manager is that an o¤-equilibrium order ‡ow of X = 2 (X = 2) is associated with the positively-informed (negatively-informed) speculator. regardless of order ‡ ow. 1 n n In Case 1 (RH > RL ). the role of the feedback e¤ect is seen in the SN B equilibrium: the feedback e¤ect increases the pro…ts that the positively-informed speculator would earn by deviating to buying. BN S. Suppose that RH < RL and > 1 . the speculator 2 is deterred from selling when she has bad news. but encouraging them to buy on good news. First. ow 1 In turn. RH . just as in the 2 scenario of < 1 (for both Case 1 and Case 2).e. Overall. RH . another important assumption is that < 1. Second. The only di¤erence is that now. the result is identical to that of the case of < 1 . investment is ex-ante n n undesirable).Proposition 4 (Equilibrium. bad news entails = H and good news entails = L. but not from buying when she has good news.

it is important that the speculator short sells rather than just sells stocks she previously owned. Our explanation for benchmarked investors’unwillingness to sell does not s require such asymmetry. The model does not apply to amplifying actions that worsen …rm value in the low state. then our limit to arbitrage may exist even if her initial position is strictly positive. existing explanations typically rely on the asymmetry in s in the ‡ ow-performance relation: the in‡ ows from beating one’ benchmark are lower than the out‡ s ows from underperforming one’ benchmark. if the speculator maximizes returns relative to other speculators or market indices rather than absolute returns (e. s 7 Note that the existence of benchmarking alone is typically insu¢ cient to explain the reluctance of mutual funds to deviate from their benchmark. our model also predicts that investors who are evaluated according to absolute returns are more likely to sell on negative information than those who are benchmarked to their peers. We would achieve the same result by instead assuming that the speculator is always present and informed. the speculator is not fully revealed and makes a positive pro…t from her private information about the state. 6 22 . While short-sales constraints do not deter selling to a non-negative …nal position. even in the absence of a short-sales constraint. but can only trade with probability – for example. may introduce other complications.g. shrinks to zero if = 1. Hence. leading to no asymmetry. Thus. the reason that the speculator loses from increasing the …rm’ value is that she ends s up with a short position. which in turn requires the speculator’ initial position s to be zero (or. i. For example. less than the amount sold) and short-sales to be possible. but sometimes she is uninformed. This is because the di¤erence in expected pro…t from buying on good information and selling on bad information stems entirely from the di¤erence in pro…t in the node where the speculator is partially revealed (X = 1 or 1). Thus. The range between 1 and 2 . hedge funds appear to sell (not just short-sell) more readily than mutual funds. This is a natural assumption if the decision maker is the …rm’ manager who attempts s to maximize …rm value via an investment decision. she is a mutual fund benchmarked against the performance of other mutual funds). if she sells half of her portfolio. If = 1. the model delivers the result that investors are more likely to engage in sales rather than shortsales. as in Goldstein and Guembel (2008). if with probability 1 she 6 receives a liquidity shock that prevents her from trading. Indeed. she increases the value of the remaining half.e. but increases the value of the entire portfolio held by her competitors.1. Third. Therefore. the value of this information depends on the manager’ decision s (as this a¤ects the dependence of …rm value on the state) and thus the feedback e¤ect. and so loses in relative terms. in which a BN S equilibrium arises and a SN B equilibrium does not arise. another potential application is to a board of directors which chooses whether to …re an underperforming manager in the bad state.7 Fourth. violate An alternative assumption would be that the speculator is always present. the feedback e¤ect can deter such selling if the speculator maximizes relative performance. However. the limit to arbitrage identi…ed by this paper may exist even in the presence of short-sales constraints. as the uninformed speculator may choose to trade to manipulate the price and the …rm’ decision. the speculator is fully revealed in these nodes and her pro…ts are zero. Where < 1. In this case. however. the real decision is a corrective action in that it improves …rm value in the low state. This. since the gains from beating one’ benchmark (by deviating) equal the s losses from underperforming one’ benchmark. at least.

4. although negative information does not cause a negative order ‡ ow (on average). we study the implications coming out of this equilibrium.assumption (2). For example. in a world of perfect information transmission.2 analyzes the impact of news on prices to generate stock return predictions. lies in between these two polar cases. reducing …rm value further (as in Goldstein. where information is partially revealed through prices. Then. 4 E¤ect of Information on Beliefs and Prices The previous section demonstrated that the feedback e¤ect gives rise to an equilibrium where a speculator buys on good news and does not trade on bad news.1 calculates the e¤ect of good and bad news on the state on the posterior beliefs q. The analysis that follows focuses on the BN S equilibrium where investment is ex-ante desirable ( < 1 ) and there is feedback ( 1 < ). the manager recognizes that X = 1 could be consistent with a negatively-informed speculator who chooses not to trade. capital providers may withdraw their investment in the low state. 1 the posterior q would equal the prior y = 2 . However. and Yuan (2011)). and will decrease his posterior accordingly. and so q (1) is no higher than q (0) (where q (X) denotes the posterior at t = 1 upon observing order ‡ X).1 Beliefs Since the manager uses the posterior belief q to guide his investment decision. In the BN S equilibrium in the proof of Proposition 1. Section 4. it can still have a negative e¤ect on beliefs and be fully conveyed to the manager. or in which the manager did not learn from prices or order ‡ ow. enabling her to pro…t more on her short position. Put di¤erently. Thus. since the information will reduce …rm value further. q measures the extent to which information reaches the manager and a¤ects his actions. In a world in which no agent observed the state. even though ow bad news can lead to a positive order ‡ of X = 1. 23 . In this section. it is not obvious that this will translate into a di¤erential impact on the manager’ beliefs. we have shown that good news received by the speculator has a di¤erent impact on her trades (and thus total order ‡ ow) than bad news. in order to study the extent to which information reaches the manager and a¤ects real decisions. and 2 2 considers both Case 1 and Case 2 together. The absolute distance between q and 1 measures the extent to which information reaches the manager. Our model. our model will have di¤erent implications: the speculator will no longer be reluctant to sell on bad news. The manager is rational s and takes into account the fact that the speculator does not sell on negative information: he updates his beliefs using the asymmetric equilibrium trading strategy. or customers or employees could terminate their relationship with a troubled …rm (Subrahmanyam and Titman (2001)). Ozdenoren. Section 4. q = 1 if = H and q = 0 if = L. the manager knows that such an order ‡ ow ow can stem from a negatively-informed and non-trading speculator. Conversely. 2 Thus far.

spec = 2 2 1+ 1 3 . Indeed. Proof. the manager’ expected posterior probability of the high state is q H = (1 3 ) + 1 + 3 s 6 3 and is increasing in . See Appendix A. Proposition 5 shows that. See Appendix A. the impact on beliefs of good news is greater in absolute terms than the impact of bad news. it may seem still possible for good and bad news to be conveyed symmetrically to the manager –by taking into account the speculator’ asymmetric trading strategy. (ii) If = L. i. the absolute increase in the manager’ posterior if the speculator receives good news exs ceeds the absolute decrease in his posterior if the speculator receives bad news. Proof. Of greater interest is to study the e¤ect of the state realization conditional upon the speculator being present.e. While the above analysis studied the e¤ect of the state being realized (regardless of whether the state is learned by any agent in the economy). the manager’ expected posterior probability of the high s H L 1 state is q L = 61 3 + 3 and is decreasing in . the e¤ects on beliefs of the high and low states being realized are symmetric. if we do not condition on the presence of the speculator..Thus. the realization of 2 2 state H has the same absolute impact on beliefs as the realization of state L. the manager’ expected s 1 1 posterior probability of the high state is q L. The goal is to investigate the extent to which the speculator’ good and bad news is s conveyed to the manager at t = 1. (ii) If = L and the speculator is present. This result holds s 24 .e. “bad news” is de…ned analogously. since in this case there is an agent in the economy who directly receives news on the state. there is feedback).spec = 3 s and is independent of . we start by showing that. (iii) We have q +q = 1 : thus.) Consider the 1 BN S equilibrium where < 2 and 1 < (i. The di¤erence is decreasing in .spec = 6 3 + 3 and is decreasing in . 2 (i) If = H. This is a direct consequence of the law of iterated expectations: the expected posterior belief must be equal to the prior.spec + q L. The results are given in Proposition 5 below: Proposition 5 (Asymmetric e¤ect of positive and bad news on beliefs at t = 1. The asymmetry is monotonically decreasing in the frequency of the speculator’ presence . the manager’ expected posterior probability of the high state is q H. (i) If = H and the 2 2 speculator is present. there is feedback). he can “undo” s the asymmetry. Lemma 3 Consider the BN S equilibrium where < 1 2 and 1 2 < (i.spec y > 2 2 0. (15) which is decreasing in . Since 6 3 > 1 .. this analysis studies the impact of the speculator receiving information about the state.spec y abs q L. We use the term “good news” to refer to = H being realized and the speculator being present. (iii) We have 1 + 61 q H. (15) implies that abs q H.e. conditional upon the speculator being present.

in order to generate stock return implications. 1g with uniform probability. it is a necessary and su¢ cient condition for bad news to have a smaller e¤ect on the manager’ belief than good s news. The asymmetry is monotonically decreasing in the frequency of the speculator’ presence . While this analysis is similar to Section 4.1 but studying prices rather than beliefs. At t = 2. The above analysis considered the change in the manager’ posterior at t = 1. there is feedback). the manager has no such inference problem and there is no asymmetry. he is unable to distinguish the case of a negatively-informed (and non-trading) speculator from that of an absent speculator (i. As we will show in Section 4. Consider the BN S equilibrium where < 1 and 1 < (i. The source of the result is that.e. Thus.even though the manager is rational and takes into account the fact that the speculator trades asymmetrically when using the order ‡ to update his prior. negative ow information has a smaller e¤ect on his belief. surprisingly this result need not hold when we examine the e¤ect of news on prices rather than posteriors. Since bad news is conveyed to the manager to a lesser extent at t = 1. and longrun drift between t = 1 and t = 2.spec y = abs q L. no information) – both of these cases lead to the order ‡ being f 1. we will show that not all the results remain the same.e. abs 0 q L. Follows from simple calculations The smaller e¤ect of bad news on the posterior at t = 1 is counterbalanced by its larger e¤ect at t = 2.2. The absolute impact 2 2 on beliefs between t = 1 and t = 2 of the realization of the state is greater for the low state = L than for the high state = H. between t = 1 and t = 2. if the speculator is always present. i.. This result is stated in Corollary 1 below: Corollary 1 (Asymmetric e¤ect of high and low state realization on beliefs at t = 2). By contrast. Thus. Just as < 1 was a necessary condition for the asymmetric feedback equilibrium to be the only equilibrium in the …rst place. We study short-run stock returns between t = 0 and t = 1.e.2 Stock Returns We now calculate the impact of the state realization and news on prices. the s state is realized and the posterior becomes either 1 (if = H) or 0 (if = L). 4. 25 .spec > 0.spec y . in which case the average posterior equals the prior of 2 and so we have abs q H. bad news causes a greater change in the posterior between t = 1 and t = 2 than good news. This can be seen by 1 plugging = 1 into equation (15). it seeps out to a greater extent ex post. s Proof. 0. ow even though the manager is rational.spec abs 1 q H.

spec p1 p0 = 6 (p ( 1) p (2)) < 0. conditional on the speculator being present. before the state has been realized.2. (16) i.spec p0 = 1 1 2 (p (2) p ( 1)) > 0. is positive: pspec 1 p0 = 11 3 2 (p (2) 26 p ( 1)) > 0: (17) . Proof. there is feedback): 2 (i) The stock price impact of the high state being realized is pH p0 = 6 [p (2) p ( 1)] > 0. Let p0 denote the “ex ante” stock price at t = 0. This di¤erence is decreasing in . there is feedback): 2 2 (i) If = H and the speculator is present.e.. 1 (ii) The stock price impact of the low state being realized is pL p0 = 6 [p ( 1) p (2)] < 1 H 0= p1 p0 .. conditional on the speculator being present. Lemma 4 is s analogous to Lemma 3 and shows that. unconditionally. (iv) The average return. Thus. 1 3 (ii) If = L and the speculator is present. good news has a greater e¤ect than bad news: Proposition 6 (Asymmetric e¤ect of positive and bad news on returns between t = 0 and t = 1. since the market maker takes into account the speculator’ trading strategy when devising his pricing function.e. Proposition 6 is analogous to Proposition 5 and shows that. This is an inevitable consequence of market e¢ ciency.1 Short-Run Stock Returns Even though the speculator trades asymmetrically. the good and bad states have the same absolute impact on prices. the average return between t = 0 and t = 1 is pH. the absolute e¤ect of the high state must equal the absolute e¤ect of the low state. 1 Lemma 4 Consider the BN S equilibrium where < 2 and 1 < (i. Since both states are equally likely. the stock price increase upon good news exceeds the stock price decrease upon bad news. (iii) The di¤erence in the absolute average returns between the speculator learning = H and = L is given by: abs pH. An uninformed investor cannot trade the stock at t = 0 and expect a non-zero average return at t = 1.) Consider the BN S equilibrium where < 1 and 1 < (i.e. We have pH p0 = pL p0 : the negative e¤ect of the low state equals the positive 1 1 e¤ect of the high state. See Appendix A. the unconditional expected return is zero.4.spec 1 p0 abs pL. the average return between t = 0 and t = 1 is L. this need not imply that realizations of the high and low states will have a di¤erential price impact.spec 1 p0 = 1 (1 3 ) (p (2) p ( 1)) > 0. The price at t = 0 is an unbiased expectation of the t = 1 expected price in the high state and the t = 1 expected price in the low state.

he is unable to distinguish the case of a negatively-informed speculator from that of an absent speculator (i.spec 2 pL.. See Appendix A. An uninformed investor cannot buy the stock at t = 0 and expect to earn a positive return at t = 1 because she will not know whether the speculator is present. 1 Consider the BN S equilibrium where < 2 and 1 < (i. the average return between t = 1 and t = 2 is pL. Proposition 6 states that the average return. which is private information. 2 1 3 (ii) If = L and the speculator is present.spec pH. Corollary 2 below shows that this need not be the case for returns: it is possible for bad news to have a smaller e¤ect than good news at both t = 1 and t = 2. to analyze the stock return analog of Corollary 1. Since good and bad news are equally likely. but can be positive or negative in Case 2. i. As with Proposition 5. Note that the positive average return given in part (iv) is not inconsistent with market e¢ ciency.This di¤erence is decreasing in . the stock price increase upon positive information exceeds the stock price decrease upon negative information (part (iii)). Corollary 2 (Asymmetric e¤ect of positive and bad news on returns between t = 1 and t = 2).spec 2 pH.2 Long-Run Drift We now move from short-run returns to calculating the long-run drift of the stock price. is positive –i. is positive (part (iv)).spec = 1 1 3 1 2 n (RL n RH ) . the average return between t = 1 and t = 2 is i i pH.e.e.. this means that the average return. the asymmetry is monotonically decreasing in .spec 1 abs pL. there is feedback): 2 (i) If = H and the speculator is present. conditional on the speculator being present. the impact of the state realization on prices between t = 1 and t = 2. Proof. If = 1.2.spec 2 pL. no information). the di¤erence in the absolute average returns between the speculator learning = H and = L is given by: abs pH. 27 .spec = 1 1 i R 3 H i RL 1 3 1 2 n (RH n RL ) . positive information is impounded into prices to a greater degree than negative information.e. even though the market maker is rational. Put di¤erently. conditional on the speculator being present. because it is conditional upon the speculator being present. (18) which is negative in Case 1. Corollary 1 showed that the smaller e¤ect of bad news on beliefs at t = 1 is counterbalanced by a larger e¤ect on beliefs at t = 2. equations (16) and (17) become zero and there is no asymmetry. 4.spec = 1 (RH RL ) > 0. the key to this result is that. (iii) If (18) < 0.e.

Since bad news has a smaller e¤ect at t = 1. if the n n feedback e¤ect is su¢ ciently strong.which is positive in Case 2 and negative in Case 1. Thus. 2 2 3 6 and the average return between t = 1 and t = 2 if the speculator is present is: pspec 2 pspec = 1 11 62 n (RL n RH ) . Proof. it must have a larger e¤ect at t = 2 (since the truth about the state comes out at t = 2). this feedback e¤ect is su¢ ciently strong to turn the average return between t = 1 and t = 2 positive. Since state L is bad for …rm value regardless of whether the manager takes the corrective action or not. 28 . By contrast. good news has a larger e¤ect on beliefs at t = 1 than bad news. i. this in turn leads to the large downward revision in beliefs in Corollary 1. the long-run drift to the low state is larger in magnitude. the return to bad news n n between t = 1 and t = 2 can be positive ((18) > 0). (RH > RL ). Indeed. the realization of state L at t = 2 leads to a large decrease in prices. In state L. (iv) Expected …rm value at t = 2. but also the manager’ action. is : 1 i 1 n 1 i pspec = RH + RL + RL . because she trades on the former but not the latter. analogous to Corollary 1. See Appendix A. In Case 2 (RH < RL ). but also this information improves the manager’ decision-making and enhances …rm value – s n n the essence of the feedback e¤ect. This is because the stock price depends not only on the beliefs about the state. and so the average increase in beliefs between t = 0 and t = 1 is reversed by an average decrease in beliefs between t = 1 and t = 2. RL is much higher than RH .e. Thus. thus. The magnitude of the di¤erence is decreasing in . Corollary 1 showed that. conditional upon the speculator being present. the expected change in beliefs between t = 0 and t = 1 is positive. the negative e¤ect of bad news is smaller than the positive e¤ect of good news between t = 1 and t = 2 as well as between t = 0 and t = 1 due to the feedback e¤ect. However. The magnitude of the di¤erence is decreasing in . which is positive in Case 2 and negative in Case 1. in Case 1. if the speculator is present. there is an additional e¤ect of the speculator on prices that s does not exist in the analysis of beliefs: not only does she convey information about the state. little bad news emerges about the state between t = 0 and t = 1. Corollary 2 shows that this need not be the case when we study prices rather than beliefs: the speculator’ presence can lead to positive average returns s in both the short-run (between t = 0 and t = 1) and also in the long-run (between t = 1 and t = 2). which means that there is a large amount of bad news to come out between t = 1 and t = 2. the e¤ect on prices in Corollary 2 is muted because the damage to …rm value caused by state L can be mitigated by taking the corrective action.

Thus.The analysis thus far has considered the impact of news on prices at t = 1 and t = 2. Proposition 7 (Faster incorporation into prices of good investment than bad investment.H 1 p0 = 1 [(2 + 2 6(2 + ) 2 i )RH + (2 i 2 )RL (2 2 n )RH n (2 + )RL ] > 0: (19) (ib) The average return between t = 1 and t = 2 is i RH pi. there is feedback): 2 (i) If investment is undertaken in state H: (ia) The average return between t = 0 and t = 1 is pi.e. i. In other words. To our knowledge. to a greater degree at t = 1) than the returns to a bad investment.. See Appendix A.e. We now consider the impact of investment (a real variable) on prices. speci…cally.1 showed that good news received by the speculator has a greater short-run price impact than bad news.) 1 Consider the BN S equilibrium where < 2 and 1 < (i. abs ((22) (21)) > abs ((20) (19)). Proof. this prediction has not yet been tested. Investing in the low state leads to negative short-run returns and negative long-run drift. Part (iii) demonstrates that the returns to a good investment are realized to a greater extent at t = 1 rather than t = 2.H = 1 1 i (R 2 H i RL ) < 0: (22) (iii) The returns to a good investment manifest more rapidly (i. are more front-loaded.e. While Section 4. the extent to which it is impounded into prices at t = 1 or at t = 2. the returns to a good investment manifest more rapidly than the returns to a bad investment. compared to a bad investment.. i. the price impact of a good investment is more front-loaded than for a bad investment. Proposition 7 now demonstrates a related result: the proportion of the total returns to an investment that is realized in the short-run (at t = 1) rather than the long-run (at t = 2) is greater for a good investment ( = H) than a bad investment ( = L).e.. 29 . Parts (i) and (ii) of Proposition 7 show that investing in the high state leads to both positive short-run returns between t = 0 and t = 1 and also positive long-run drift between t = 1 and t = 2..2.H = 1 i i RH RL > 0: 2+ (20) (ii) If investment is undertaken in state L: (iia) The average return between t = 0 and t = 1 is 1 [(1 6 i ) RH n i RH + RL n RL ] < 0: (21) (iib) The average return between t = 1 and t = 2 is i RL pi.

If speculators sold aggressively in response to a bad investment. which will likely diminish with the development of …nancial markets. which exist even in developed …nancial markets). If the investment is bad. this force will also diminish. and so may continue to persist over time. All agents in the model act with full rationality: the market maker takes into account the manager’ learning when setting the price. the intuition is as follows. investor irrationality or investors’limited information on the quality of a portfolio manager. she endogenously chooses not to trade because of the feedback e¤ect. which leads to mutual funds avoiding arbitrage trading that will only converge in the long run (Shleifer and Vishny (1997)). Thus. there are bad investments that do not lead to a sharply negative reaction at t = 1 because the speculator did not trade on the bad news. By contrast. and this in s turn a¤ects the speculator’ decision to trade. Either way. the valuedestructiveness of the investment seeps out ex post. which means that the market maker cannot distinguish the case of a negatively-informed speculator from that of an uninformed speculator. If anything. if investor sophistication and information improve over time. The …rst is that this paper identi…es a limit to arbitrage which. One existing source of limited arbitrage is market frictions such as short-sales constraints. the limit to arbitrage analyzed by this paper stems from …rm value being endogenous to the act of arbitrage. this arises from the fact that < 1. the negative returns must manifest predominantly at t = 2. the limit to arbitrage may increase with investor sophistication. 5 Summary of Implications This section discusses several implications of our model. is likely to persist over time even as markets evolve and investors become more sophisticated. A second is that investors in professional money managers make their allocation decisions based on short-run measures of performance. There is no exogenous friction preventing the arbitrageur from trading. The key to reconciling this result with market e¢ ciency is that …rm value is endogenous to trading. In both Propositions 6 and 7. as this augments the extent to which speculators have value-relevant 30 . Thus. Note that the long-term drift in returns does not violate market e¢ ciency.The intuition behind the asymmetry is di¤erent from Proposition 6. the asymmetry occurs because the low state has a lesser impact on prices than the high state. instead. Such behavior can either be irrational over-extrapolation. (The only market imperfection that our model requires is trading costs. the market maker knows that the speculator is s pursuing an asymmetric trading strategy. This is a fundamental force that does not rely on short-sale constraints. Here. Instead. the negative returns must manifest predominantly at t = 2. or rational if investors have limited information on the fund manager’ quality but instead must infer it s imperfectly from short-run performance. Put di¤erently. in contrast to alternative explanations. the decline in the stock price will lead to the investment being cancelled. In Proposition 6. otherwise the decline in the stock price will have led to the investment being canceled. the negative returns cannot manifest too strongly at t = 1.

By contrast. In particular. While the above results are unconditional on investment occurring. This prediction has implications for trading volume. Thus. Their reluctance to disseminate bad news is not because they are evaluated according to the stock price. but also the manager’ decision. because the speculator trades more readily on good news than bad news. Thus. but due to the limit to arbitrage created by the feedback e¤ect. Such a relation is consistent with the well-documented positive correlation between trading volume and stock returns (see. and they dissems inate favorable information more enthusiastically than unfavorable information because they are evaluated according to the stock price. it must be counterbalanced by a larger long-run drift. Even though less bad news is transmitted to the market at t = 1. It does not address the predictability of future returns from past returns. While the speculator buys on good information. s the manager can take a corrective action to mitigate the negative impact of the state on …rm value. Proposition 6 shows that negative information will enter into prices more slowly. Our theoretical model o¤ers a potential alternative explanation. Moreover. if speculators choose not to trade on negative information. Hong and Stein do not predict an asymmetry between good and bad news. in an underreaction model. Moreover. leading to overinvestment –even though there is an agent who knows Note that our paper focuses on the e¤ect of news on stock prices. While Hong. Proposition 7 shows that the returns to good investment are more front-loaded than the returns to a bad investment. e. so the e¤ect of bad news on returns is lower at t = 2 as well as at t = 1. if bad news has a smaller e¤ect on short-run returns than good news. Lim. the feedback e¤ect means that the lack of negative information in prices will have further consequences on real decisions. Karpo¤ (1987)). who disseminate information not s through public news releases. and Stein (2000).and long-run returns to investment. meaning that there is more to come out at t = 2. and Stein’ results are consistent with the Hong and Stein (1999) model s that news travels more slowly in small …rms with low analyst coverage. leading to negative long-run returns as documented by Agrawal. bad news generates a smaller e¤ect on returns in both the short-run and long-run. the model also generates implications for the short. Another di¤erence is that. In our feedback model. which is another component of the Hong. and Stein speculate that the asymmetry arises because key information is held by the …rm’ managers. even though the market maker takes the asymmetric trading volume into account. Lim. some negative-NPV projects will not s be optimally abandoned. stock returns depend not only on the state. and Mandelker (1992) and Rau and Vermaelen (1998). then such negative information does not become incorporated into stock prices and fails to in‡ uence the manager’ behavior.information which the manager attempts to learn by observing the price. suggesting that volume should be higher upon good investments (such as M&A or capital expenditure) than bad investments. Key information is held by a …rm’ investors. the value-destructiveness of a bad investment seeps out to a greater extent ex post. Ja¤e.8 Hong. and Stein (2000) …ndings. Lim. 8 31 .. Lim. she does not sell on bad information. as found empirically by Hong. but by trading on it. The second main category of applications stems from the fact that the limit to arbitrage is asymmetric. Corollary 2 shows that.g. in some cases.

This may explain why a large proportion of M&A deals destroy value (see. Trading in either direction impounds information into prices. In the model. bad news has a smaller e¤ect on short-run prices than good news. While he …nds that some transactions are canceled in equilibrium. Andrade. There are several important di¤erences between the feedback-driven limit to arbitrage that we study.. or holding costs. Even if a speculator has negative information on the state. In contrast. Interestingly. our e¤ect is asymmetric. as in the standard theories of Jensen (1986). the smaller short-run reaction to bad news may also coincide with smaller long-run drift. and sometimes causes her to realize a loss. our model suggests that there are other negative-NPV deals that should optimally be canceled but are not because speculators do not impound their negative views into prices. which improves the manager’ decision-making and increases fundamental value. The asymmetry of our e¤ect has implications for both stock returns and real investment.with certainty that the investment is undesirable. Stulz (1990) and Zwiebel (1996). Luo (2005) shows that managers sometimes use the market reaction to announced M&A deals to guide whether they should cancel the acquisition. holding costs or portfolio delegation. noise trader risk. she may strategically refrain from trading on it. since the manager can take a corrective action to attenuate the negative e¤ect of the state on …rm 32 . because doing so conveys her information to the manager. This increases the pro…tability of s a long position but reduces the pro…tability of a short position. overinvestment does not occur because the manager is pursuing private bene…ts. the e¤ect is generated endogenously as part of the arbitrage process. but is unable to do so since speculators refrain from impounding their information into prices. Mitchell and Sta¤ord (2001). it still takes place. even though the market maker is rational and takes the speculator’ trading strategy into s account when devising his pricing function. the manager is fully aligned with …rm value and there are no agency problems. instead. In terms of stock returns. we have d = i if the noise trader does not sell.g. The above overinvestment result can apply to M&A as well as organic expansion. even if = L. First. thus encouraging buying on good news but discouraging selling on bad news. Critically. Overinvestment occurs even though the manager is fully aware that the speculator does not trade on negative information and takes this into account. e. in contrast to underreaction models. unlike limits to arbitrage based on short-sale constraints. The manager may then take a corrective action that improves …rm value but reduces the pro…ts from her short position below the cost of trading.) 6 Conclusion This paper has modeled a limit to arbitrage that stems from the fact that …rm value is endogenous to the act of exploiting the arbitrage. and the limits to arbitrage identi…ed by prior literature. The manager wishes to maximize …rm value by learning from prices. Second. our model does not rely on exogenous forces or agency problems. unlike limits to arbitrage based on fundamental risk.

In addition.value. the valuedestructiveness of a bad investment seeps out ex post. 33 . even though there are no agency problems and he is attempting to learn from the market to take the e¢ cient decision. In terms of real investment. the returns to a good investment are more front-loaded than the returns to a bad investment –since the speculator does not trade on negative information. Even though there is an agent in the economy who knows with certainty that the investment is undesirable. this information is not s conveyed to the manager and so the project is not abandoned. and the manager is aware of the speculator’ asymmetric trading strategy. the manager may overinvest in negative-NPV projects.

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1g are observed on the equilibrium path and so the posteriors can be calculated by Bayes’rule: q(X) = Pr(HjX) = We thus have: q( 1) = (1=3) + (1 )(1=3) (1=3) + (1 )(1=3) + (1=3) + (1 )(1=3) Pr(XjH) : Pr(XjH) + Pr(XjL) 1 = . if and only if 3 . if a negatively-informed speculator sells. Thus. X = 1 and she pays 1 RH + 1 RL per share. 1 .p. trading pro…ts are zero. and so her pro…t is 2 (RH RL ) > 0. Sequential rationality leads to the decisions d and prices p as given by the Table. the no-trade equilibrium is sustainable. her gross pro…t is also given by (23). Thus. The order ‡ ows of X 2 f 1. i i W. as these are the only posteriors that satisfy the Intuitive Criterion (as stated in the main proof). If the positively-informed speculator chooses to deviate from not trading to buying: 1 With probability (w. The order ‡ of X = 2 is o¤ the equilibrium path and ow 37 . The fundamental value of each share 3 2 2 1 i i i is RH . The fundamental value of each share 3 2 2 1 i i i is RH . and so her pro…t is 2 (RH RL ) > 0. We now turn to calculating trading pro…ts. 1 . i i W. No Trade Equilibrium NT. The order ‡ ows of X = 2 and X = 2 are o¤ the equilibrium path and the posteriors are given by 0 and 1. 0. X = 2 and she is fully revealed. X = 0 and she pays 1 RH + 1 RL per share.A Proofs Proof of Proposition 1 This proof only provides supplementary material to what is in the text. Partial Trade Equilibrium SNB. 2 and q (0) and q (1) are calculated in exactly the same way.p.) 3 .p. Thus. respectively. her expected gross pro…t is given by: 11 i R 32 H i RL + 11 i R 32 H i RL = 1 i R 3 H i RL = 3: (23) A similar calculation shows that.

The fundamental value of each 3 2 2 i i i share is RL . and so her pro…t is 1 (RH RL ) > 0. X = 0 and she receives 1 RH + 1 RL per share.the posterior is given by 1. The fundamental value of each share 3 2 2 1 i i i is RH . and so her pro…t is 2 (RH RL ) > 0. 1 i i W. The fundamental value of each 3 2 i i i share is RL . 1 . 3 . 1 . 2 i i W. The order ‡ of X = ow 2 < 3. the SNB equilibrium is sustainable if and only if Partial Trade Equilibrium BNS. the negatively-informed speculator sells. 1 . X = 3 2 and she is fully revealed. trading pro…ts are zero. 2 is o¤ the equilibrium path and 38 . Thus.p. W. 3 . 1 . The posteriors of the other order ‡ ows are given as follows: q( 2) = q ( 1) = 0 =0 (1=3) 1 2 1 2 (1=3) + (1 )(1=3) = (1=3) + (1 )(1=3) + (1=3) + (1 )(1=3) (1=3) + (1 )(1=3) = q (0) = (1=3) + (1 )(1=3) + (1=3) + (1 )(1=3) (1=3) + (1 )(1=3) 1 q(1) = = : (1=3) + (1 )(1=3) + (1 )(1=3) 2 Under this equilibrium. 2 i i W.p. 2 Thus.p. 1 i i W. and so her pro…t is 1 (RH RL ) > 0. her expected gross pro…t is given by: 1 3 1 1 + 2 2 i RH i RL = 2. The fundamental value of each 2 i i i share is RH . X = 1 and she receives 1 RH + 2 RL per share. Thus.p. Thus.p. and so her pro…t is 1 (RH RL ) > 0. Thus. X = 0 and she pays 1 RH + 1 RL per share. X = 2 and she is fully revealed. X = 1 and she pays 2 1 RH + 1 RL per share.p. her expected gross pro…t is given by: 1 i R 3 H i RL = 3: If the positively-informed speculator deviates to buying: 1 W. trading pro…ts are zero.

2 i i W. The pro…ts from deviating to selling on negative information are now given as follows: W. 1.p. The fundamental value 3 n of each share is RL because the manager is now taking the corrective action.the posterior is given by 0. and so her pro…t is 1 (RH RL ) > 0. if the negatively-informed speculator deviates to selling. X = 0 and she receives 1 RH + 1 RL per share. 1 . All order ‡ ows are on the equilibrium path and so the posteriors are 39 . analogous to the SNB equilibrium. The fundamental value of each 3 2 2 i i i share is RL . trading pro…ts are zero. 1 . she earns pro…ts of 2 . 1 n n W. X = 1 and she receives 2 RH + 2 1 RL per share. Hence. this 1 equilibrium is sustainable if and only if 2 < 3 . buying on good information) yields pro…ts of 3 . informed trading (in this case. this equilibrium is sustainable if and only if 1 < Trade Equilibrium T. Thus. 2 Thus. and so her n n pro…t is 1 (RH RL ) > 0.p. The posteriors of the other order ‡ ows are given as follows: q ( 1) = (1 )(1=3) 1 = (1 )(1=3) + (1=3) + (1 )(1=3) 2 (1=3) + (1 )(1=3) 1 q (0) = = (1=3) + (1 )(1=3) + (1=3) + (1 )(1=3) 2 1 (1=3) + (1 )(1=3) = q(1) = (1=3) + (1 )(1=3) + (1=3) + (1 )(1=3) 2 (1=3) = 1: q(2) = (1=3) There are two sub-cases to consider.p. The pro…ts from ow trading on positive information are unchanged. 1 . For the sub-case of feedback ( 2 < ). the manager now takes decision d = n upon observing order ‡ X = 1. her expected gross pro…t is given by: 1 3 1 i R 2 H i RL + 1 2 n (RH n RL ) = 3. Thus. In the sub-case of no feedback ( 1 > ). X = 3 2 and she is fully revealed. decision 2 d = i is taken for all of the order ‡ ows on the equilibrium path. Thus.

p. X = 0 and she receives 1 RH + 1 RL for a share that is worth RH . the 2 pro…ts are given by 2 and so the equilibrium is sustainable if and only if < 2 . No Trade Equilibrium NT. 3 . Here we calculate the pro…ts made if the positively-informed speculator deviates to selling. Without feedback ( 1 > ). X = 2 and she receives RL for a share that is worth RH . 2 Proof of Proposition 3 This proof only provides supplementary material to what is in the text. 1 i i i W. as in the SN B equilibrium.p.given as follows: q( 2) = q ( 1) = 0 =0 (1=3) (1 )(1=3) 1 = (1 )(1=3) + (1=3) + (1 )(1=3) 2 1 (1=3) + (1 )(1=3) = q (0) = (1=3) + (1 )(1=3) + (1=3) + (1 )(1=3) 2 (1=3) + (1 )(1=3) 1 q(1) = = (1=3) + (1 )(1=3) + (1 )(1=3) 2 (1=3) = 1: q(2) = (1=3) The pro…ts from buying on positive information are given by 2 . the pro…ts are given by 1 and so the equilibrium is sustainable if and only if < 1 . her overall pro…ts are given by 1 n (R 3 L n RH ) + 1 i R 3 L i RH . 1 . which yields 3 2 i i a pro…t of 1 (RL RH ) < 0. Thus. As discussed in the main text. For the positively-informed speculator not to deviate to selling. we require 1 3 i RH i n RL + (RL n RH ) < : 40 . which yields a pro…t n n of (RL RH ) > 0. to derive the necessary conditions to prevent such a deviation. For the pro…ts from selling on negative information. 2 1 i i i W. there are two sub-cases to consider. If the positively-informed speculator deviates to selling: 1 n n W. which correspond to the two sub-cases in the BN S equilibrium. With feedback ( 1 > ). which yields a 2 2 1 i i pro…t of 2 (RL RH ) < 0. it is straightforward to show that the negatively-informed speculator will not deviate to buying. 3 . X = 1 and she receives 2 RH + 1 RL for a share that is worth RH .p.

If the positively-informed speculator deviates to selling: n n W. which yields a pro…t of 2 1 (RL RH ) > 0. This requires: 1 i R 3 H 3 i R 2 H i RL > i RL 1 3 3 > 2 3 2 n (RL n (RL n RH ) 1 3 1 i R 2 H i RL n RH ) : The …rst term is the “fundamental” e¤ect. her overall pro…ts are given by 1 n 1 1 n i (RL RH ) + RL 3 32 1 n 1 4 n = (RL RH ) 3 3 4 2 i RH + i RH 1 3 i RL 1 i R 2 L . i RH 41 . which yields a pro…t 3 n n of (RL RH ) > 0. X = 1. which arises s because selling manipulates the order ‡ and causes the manager to take the wrong decision. X = 2 and she receives RL for a share that is worth RH . In the case of no 1 i i i feedback ( 1 > ). n n W. The second term is the “feedback” e¤ect. In the case of no feedback. she receives 1 RH + 2 1 RL for 3 2 2 n n n a share that is worth RH . she receives 2 RH + 2 1 RL for a share that is worth RH . In the case of feedback ( 1 < ). which yields a 2 2 1 i i pro…t of 2 (RL RH ) < 0. 1 i i i W.The calculations for the Partial Trade Equilibrium SN B are identical. which represents the pro…ts from trading in the direction of one’ private information. X = 0 and she receives 1 RH + 1 RL for a share that is worth RH .p. her overall pro…ts are given by 1 1 1 1 n n n n (RL RH ) + (RL RH ) + 3 32 3 1 1 i 1 3 n n (RL RH ) R = 3 2 3 2 H 1 i R 2 L i RL i RH . For the positively-informed speculator to choose buying over selling. 1 . her pro…ts must be greater under the former. 3 .p. ow 6 3 i i This yields the condition 6 2 (RH RL ) > 1 in the Proposition. which 2 i i yields a pro…t of 2 1 (RL RH ) < 0. 1 . Partial Trade Equilibrium BNS. In the case of feedback.p.

In the case of feedback. the pro…ts from buying (that we need to compare against the pro…ts from selling) are di¤erent. 6 3 3 3 ) 1 1 1 q (0) + q (1) + q (2) 3 3 3 (24) 42 . However. for the positively-informed speculator to choose buying over selling. we require: 1 3 1 1 + 2 2 i RH i 3 2 RH n 3 RL i RL > 1 3 3 2 n (RL n RH ) 1 3 1 i R 2 H i RL i RL > 1. if = H. n RH In the case of no feedback. for the positively-informed speculator to choose buying over selling. If the positively-informed speculator deviates to selling. the calculations are exactly the same as in the Partial Trade Equilibrium BN S. we require: 1 i 1 n i RH RL > (RL 3 3 i i 8 3 RH RL > 1: n n 4 2 RL RH n RH ) 1 3 4 4 2 i RH i RL Trade Equilibrium T. we require: 1 3 1 1 + 2 2 i RH i RH 2 n RL i RL > 1 n (R 3 L n RH ) 1 3 4 4 2 i RH i RL i RL > 1: n RH Proof of Lemma 3 For part (i).For the positively-informed speculator to choose buying over selling. the expected posterior is given by: q H = (1 1 1 1 q ( 1) + q (0) + q (1) + 3 3 3 1 1 1 = q ( 1) + q (0) + q (1) + q (2) 3 3 3 3 (1 )2 1 = + + .

spec (27) Note that q H. we have: q H. X 2 f0. Since we are conditioning on the speculator being present. the greater the likelihood that X = 1 stems from = L.We have: @q H 1 1 = + @ 3 3 " 1 = 1+ 3 = 1 1 3 2(1 1 2 1 2 )(2 (2 2 2 2 1 2 ) + (1 )2 # )2 > 0: The expected posterior is increasing in : if the speculator is more likely to be present. it can change the actual posterior given a certain order ‡ ow. Moving to part (ii). Part (iii) follows from simple calculations. it is not consistent with the speculator observing = H. With = L. but q L. 1. 43 . we have: qL = 1 (q ( 1) + q (0) + q (1)) 3 1 1 + : = 6 3 3 (25) This is decreasing in . and second. The variable can a¤ect the expected posterior in two ways: …rst. This is consistent with the speculator being absent (in which ow case the state may be either H or L) or her being present and observing = L. there is a 1 probability 3 that the order ‡ is X = 1. 3 1 = (q ( 1) + q (0) + q (1)) 3 1 1 = + . her information is still partially incorporated into prices. The greater the likelihood that the speculator is present.spec is decreasing in . 6 3 3 (26) q L. the …rst channel is ruled out: conditional on the speculator being present and = H.spec = 1 (q (0) + q (1) + q (2)) 3 2 = . she is more likely to impound her information into prices by trading. 2g with uniform probability regardless of . if = L. Even though the speculator does not trade upon = L if she is present. and thus the greater the decrease in the market maker’ posterior. it can change the relative likelihood of the di¤erent order ‡ ows. s Proof of Proposition 5 For parts (i) and (ii).spec is independent of .

the expected price at t = 1 is given by: pH = (1 1 1 1 1 1 1 1 p ( 1) + p (0) + p (1) + p (0) + p (1) + p (2) 3 3 3 3 3 3 1 1 1 = p ( 1) + p (0) + p (1) + p (2) : 3 3 3 3 ) (29) 44 . she always buys in state H. Moreover. 1g is completely uninformative and so the posterior is again independent of . the state will be = L and there is no trade. If the speculator is present. ow the price at t = 0 will be the expectation over all possible future prices at t = 1. the state will be = H. If she is absent. X 2 f0. 0. and is given as follows: p0 = 2 1 1 = 3 1 = (1 6 1 1 1 p (0) + p (1) + p (2) + 1 3 3 3 2 2 1 1 1 p ( 1) + p (0) + p (1) 3 3 3 p ( 1) + p (0) + p (1) + p (2) 2 (28) n n i i )RH + RL + (2 + )RH + 2RL : Even though the initial belief y is independent of . n i i n reducing …rm value by (RH RH ). if = H is realized. This is because. the only posterior that depends on is q ( 1): since X = 1 is inconsistent with the speculator being present and seeing = H. 0. Proof of Lemma 4 We start by calculating p0 . Part (iii) follows from simple calculations. By contrast. @p0 is independent of RL and RL . 2g. the initial stock price p0 is increasing in . there is a possibility that X = 1. since she does not trade. Turning to the second channel. 1. By contrast. 1 With probability 2 . This leads the manager to take the suboptimal corrective action. X 2 f 2. 1g with equal probability. X 2 f 1.spec does not. s @p0 n i is increasing in (RH RH ). 1g. With probability 1 . if the low state is realized. 0. because the speculator provides information to improve the manager’ decision. X 2 f0. it has a particularly negative impact on the likelihood of = H if the speculator is more likely to be present. which guarantees that X 0 and the investment is undertaken. If the speculator is present. 2g is fully revealing and so the posterior is independent of . 1g with uniform probability regardless of . Letting p (X) denote the stock price set by the market maker after observing order ‡ X at t = 1.conditional on the speculator being present and = L. 2 regardless of whether the speculator is present. X 2 f 1. only q L. This is intuitive. Since X = 1 can only occur in the presence of a speculator if she has received bad news. the increase in …rm value from taking the e¢ cient continuation @ decision in the high state. (1 )). the …rm @ values in the low state. Thus. If the speculator is absent (w.spec depends on but q L. there is no trade and we again have X 2 f 1.p. s For part (i). the speculator’ presence s does nothing to help the manager’ decision.

spec 1 1 p ( 1) + p (0) + p (1) + p (2) 2 2 1 2 n RL > 0. if the speculator receives positive information.spec = 1 1 (p (0) + p (1) + p (2)) : 3 (31) Unlike pH (equation (29)). pH is increasing in . the expected price at t = 1 is given by: pL = 1 @pL Rn Rn 1 (p ( 1) + p (0) + p (1)) : 3 (30) L We have @ 1 = 3(2 )H . The stock return realized when the speculator receives good information is thus given by: pH. if = L is realized. for the same reasons that q H. i.spec (equa1 tion (26)) is independent of .Note that: @pH 1 1 1 1 = p(2) p( 1) + @ 3 3 3 1 1 i = RH Rn 3 (2 )2 L 1 i n > [RH RL ] 3 > 0.e. the price is higher if and only if …rm value is higher in this n n state. (32) and we have 1 n i = [RH RH ] < 0: @ 6 Equation (32) is decreasing in . @p( 1) @ 1 1 (2 )2 n RH i. then X = 1 is more 2 likely to result from = L. The calculations of pH p0 and pL p0 follow automatically.. If the speculator is more likely to be present. Turning to part (ii). this is independent of . RL > RH (Case 2). Thus. since the speculator impounds information about the high state into 1 prices. 1 1 Proof of Proposition 6 For part (i). she will buy one share and so the expected price becomes: pH. whereas the stock return not conditioning on the speculap0 45 .spec 1 p0 = 1 1 (p (0) + p (1) + p (2)) 3 3 1 = 1 (p (2) p ( 1)) 3 2 1 1 i n = 1 RH RH 3 2 2 @ pH.e.

= 1 i R 3 H Moving to part (ii). Proof of Corollary 2 We start with part (i). but pH. both equation (16) (the asymmetry between the price impact of good and bad news) and equation (17) (the average return.spec = 1 and pL. we have a convex n i n i i n n combination of RH and RL . conditional on the speculator being present) become: 1 1 i n n (1 ) RH RH RL : 2 2 Di¤erentiating with respect to i RH + gives: 1 2 n RL + (1 1 2 3 n RH + ) 1 (2 ) n 2 RH 1 (2 )2 n RL = i RH + 4 + 2 n 1 n 2 RH + 2 RL (2 ) (2 ) n n The coe¢ cients of RH and RL are positive and add up to one. since RH > RH and RH > RL . both equations (16) and (17) are decreasing in . We thus have pL. else it will be continued.spec = RH 1 1 (p (0) + p (1) + p (2)) 3 i RL .spec = RH .spec 2 i pH. The project will i n be cancelled if the noise trader sells. we have: pL. if the speculator is present and receives negative information. This is because p0 is increasing in .spec is s 1 independent of . If the speculator receives good news. she will not trade. We thus have pH.spec 1 p0 = = 1 (p ( 1) + p (0) + p (1)) 3 6 (p ( 1) p (2)) = pL 1 1 3 p0 < 0. Dropping constants. which is smaller that RH . (32).spec = 2 RL + 1 RL . 1 3 (33) Parts (iii) and (iv) follow from simple calculations. That is. Thus. For part (ii). 2 3 3 46 . 1 2 p ( 1) + p (0) + p (1) + p (2) 2 1 (p ( 1) + p (0) + p (1)) = pL . This yields: 2 pH. was increasing in . if the speculator receives bad news. she will buy and so the project i will always be undertaken.tor’ presence.

p. we have d = n and so v = RL . 0. we have d = i and so v = RL . 2g with uniform probability and the investment is always undertaken. 2 2 3 6 and so we have pspec 2 pspec = 1 11 62 n (RL n RH ) . which is positive if we are in Case 2 and negative if we are in Case 1. which yields X 2 f 1. Part (iii) follows from simple calculations. not conditioning on the state. we …rst calculate pi. From we have >1 .H 1 (p(0) + p(1) + p(2)) + 1 2 1 (p(0) + p(1)) 3 = 1 + (1 )2 2 3 p(0) + p(1) + p(2) = . For part (iv). so X 2 f0.p. Proof of Proposition 7 We start with some preliminary results that will be useful in the main proof. Let min = 1 n i n n RH RL RH RL ~n RL = (1 1 n RH ]. 1g.spec 2 2 i 1 n 1 pL. If X = 1. We have = H w. W. . she will trade 1 on her positive signal and impound it into prices. If = L. Expected …rm value at t = 2 is thus given by: 1 i 1 n 1 i pspec = RH + RL + RL . ~i Note that RH > 0 from equation (1). the speculator is present and buys. 1. We therefore have: pi. we …rst calculate the expected …rm value at t = 2 if the speculator is present. (34) ~i min )RH ~i + RL : For part (i). If = H. so there is no trade. W. 1).This yields: pL. 1g. 2 .spec = RL + RL (p ( 1) + p (0) + p (1)) 1 3 3 3 1 i 1 1 i n n = RH RL (RH RL ) .p. the project is always undertaken. regardless of the order ‡ at t = 1. 2+ 1 23 Simple calculations show that pi. 1 the speculator is absent. the expected stock price at t = 1 if investment has been 1 1 undertaken and the state is good.H is increasing in : if the speculator is present. 1 2 < and max = 1. ow i and so …rm value v = RH . whether the project is undertaken depends on the order n i ‡ ow: if X = 1. Note that this argument did not apply to 47 . 3 3 2 which can be positive or negative. if X 2 f0. 1 which implies that 2 (1 1 i ~i ~i ~n De…ne [RH RL RL ] = [RH Equation (5) thus yields: .H . we have d = n so we exclude this case.

For part (ia). equation (36) reduces to 3RH 3RL > 0. the long-run drift is given by: i RH i pi. 2g were all equally likely. If X = 1. Thus. We therefore have: pi. Thus. At = min . This rules out the case of p ( 1) which is the only price that depends on . L.spec (equation (26)) and pH.L . (35) The sign of (35) is the same as the sign of (2 + 2 = (2 + 2 2 i n i n ) RH RH + (2 2 ) RL RH 2 ~i ~i ~n )RH + (2 2 )RL (2 + )RL . X = 2 is particularly likely if the speculator is present. 2 This is independent of since the presence of the speculator does not change the order ‡ ow.spec (equation (31)) because those quantities are conditional on 1 the speculator being present.spec L Unlike in the earlier cases of p1 and p1 which did depend on . it is su¢ cient to prove that it is positive at both min ~n ~i and max .H = RH 1 = i RH 2+ p(2) + p(1) + p(0) 2+ i RL > 0: (37) For part (ii). equation (35) is positive. and so its minimum occurs at either min or max . At = max . we …rst calculate pi. so X = f0. we have d = n so we exclude ow this case.H 1 p0 = p(2) + p(1) + p(0) 1 1 p ( 1) + p (0) + p (1) + 2+ 3 2 2 1 1 1 4 p(2) + p(1) + p(0) p( = 6(2 + ) 3(2 + ) 3(2 + ) 3 6 1 2 i i 2 n = [(2 + 2 )RH + (2 2 )RL (2 )RH 6(2 + ) p (2) 2 1) n (2 + )RL ]. it reduces to ~i ~i 3 min (RH RL ) > 0.q H. to prove that (36) > 0. the short-run return to an investment (d = i) in the high state is given by: pi. (2 2 n ) (RH n RH ) n (2 + ) (RL n RH ) (36) Equation (36) is quadratic and concave in . the order ‡ will be X 2 f 1.L 1 = 1 2 1 p (0) 3 1 2 + 1 p (1) 3 2 3 = 1 (p(0) + p(1)) . 1. Regardless of whether the speculator is present. Here. here we are conditioning upon the investment being undertaken. 0. the expected stock price at t = 1 if investment has been 1 undertaken and the state is bad. For part (ib). 1g with uniform probability. 48 .

If RL ~i 0. i.e. s For part (iib). it is automatic that (41) > 0. the long-run drift is given by: i RL i pi. we …rst calculate the di¤erence between the long-run drift and the short-run return to a good investment. To prove this is positive. 6 1 3 p( 1) 6 (38) The sign of (38) is the same as the sign of: (1 i n n n i ) RH RH (RH RH ) + RL ~n ~i ~i = (1 )RH + RL RL . Since pi. equation (38) is negative. This yields: 1 1 2 ~i ~i ~i ~i (RH RL ) [(2 + 2 )RH + (2 2 )RL 2+ 6(2 + ) 1 ~n ~i ~i = [(4 2 + 2 )RH (8 2 )RL + (2 + )RL ]. we must prove that ~i ~i ~n (4 2 + 2 )RH (8 2 )RL + (2 + )RL (41) ~i is positive. 1 For part (iii). since RH > 0. (37)-(35). we must …rst sign (37)-(35).L 1 p0 = 1 1 1 (p(0) + p(1)) p(2) + p(1) + p(0) + 2 6 3 3 1 1 1 p(2) + p(1) + p(0) ( )p( 1) = 6 6 6 3 6 1 i n i n = [(1 ) RH RH + RL RL ]. and p0 is increasing in (because the speculator improves 1 the manager’ decisions). Suppose RL > 0. the short-run return to an investment in the low state is: pi. since pi.L is independent of . 6(2 + ) ~n (2 + )RL ] In order to calculate abs ((37) (35)).For part (iia).L is independent of . Thus. from equation (34). Evaluating (41) at min 49 .L = RL 1 ~i min )RH ~i + RL ~n RL 1 (p(0) + p(1)) 2 i RL ) < 0 = 1 i (R 2 H (40) and independent of . the absolute return is decreasing in . n RH n (RL n RH ) (39) ~i Equation (39) is decreasing in . This implies that (1 ~i ~i )RH + RL ~n RL < (1 = 0.

(40) (38). At = max . we have (42) > 0: Finally.e. respectively. Suppose that (41) is not monotonic in .and max . max ). The sign of abs ((40) (38)) 50 . we must prove that i RL ) i )RH 1 [(1 6 i 2RL i i )RH + RL n RL ]. we wish to show that abs ((40) (38)) > abs ((37) (35)). The derivative of (41) is equal to ~i ~i ~n (2 2 )RH + 2RL + RL : Then 0 =1 ~i ~n 2RL + RL . which implies (41) > (4 ~i ~i ~i )RH (8 2 )RL + 4(2 + )RL ~i ~i ~i = (4 2 + 2 )RH RH + 6 RL ~i > 0 for RL > 0: 2 + 2 We now calculate the di¤erence between the long-run drift and the short-run return to a good investment. yields 1 ~n ~i ~i ~n RL RL 2RL + RL >1 ~i ~i 2RH RH ~ ~i ~ ~n Rn Ri 2RL + RL < L i L ) ~ ~ 2Ri R H H ~i ~n ) 4RL < RL . Then its derivative with respect to must have a root 0 2 ( min . equation (42) becomes 3RH 2RL RL > 0. it follows that (41) > 0. This yields: 1 i (R 2 H 1 = [(4 6 In order to calculate abs ((40) negative. n RL ] (38)). yields min = = :(4 2 min + 2 ~i min )RH (8 2 ~i min )RL + (2 + min )[(1 ~i min )RH ~i + RL ] max ~i = (6 3 min )RH (6 3 ~i ~i ~n :3RH 6RL + 3RL > 0: ~i min )RL > 0: If (41) is monotonic in in its feasible range. ~ 2R i H The condition 0 > min . To prove this is (42) ~i ~i ~n is positive. we must …rst sign (40) (4 ~i )RH ~i 2RL ~n RL (38). together with (34). i. Since (42) is decreasing in lambda.

51 . 2 ~i (43) = 2(2 + 2 min min )RH + 4(1 ~i ~i = 6 min (RH RL ) > 0. and so abs ((40) (38)) abs ((37) > (35)). (43) is always positive. Then its minimum occurs at either ~i ~n = max . or max . At ~i min )RL 2(2 + min )[(1 ~i min )RH ~i + RL ] Thus.abs ((37) (35)) is equal to the sign of: ~i ~i ~n )RH 2RL RL ] 2 ~i ~i )RH (4 + 2 )RL 2 ~i ~i )RL )RH + 4(1 ~i ~i ~n 2 + 2 )RH (8 2 )RL + (2 + )RL ] ~n ~i ~i ~n (2 + )RL ] [(4 2 + 2 )RH (8 2 )RL + (2 + )RL ] ~n (43) 2(2 + )RL : [(4 min (2 + )[(4 =[(8 + 2 =2(2 + 2 (43) is quadratic and concave in . For = min . (43) reduces to 6(RH RL ) > 0.