Information Aggregation, Investment, and Managerial Incentives

Elias Albagli, Christian Hellwig and Aleh Tsyvinski
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Elias Albagli: USC Marshall

No 1816, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: We study the interplay of share prices and firm decisions when share prices aggregate and convey noisy information about fundamentals to investors and managers. First, we show that the informational feedback between the firm's share price and its investment decisions leads to a systematic premium in the firm's share price relative to expected dividends. Noisy information aggregation leads to excess price volatility, over-valuation of shares in response to good news, and undervaluation in response to bad news. By optimally increasing its exposure to fundamental risks when the market price conveys good news, the firm shifts its dividend risk to the upside, which amplifies the overvaluation and explains the premium. Second, we argue that explicitly linking managerial compensation to share prices gives managers an incentive to manipulate the firm's decisions to their own benefit. The managers take advantage of shareholders by taking excessive investment risks when the market is optimistic, and investing too little when the market is pessimistic. The amplified upside exposure is rewarded by the market through a higher share price, but is inefficient from the perspective of dividend value.

Pages: 37 pages
Date: 2011-08
New Economics Papers: this item is included in nep-cta and nep-hrm
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Citations: View citations in EconPapers (2)

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Related works:
Working Paper: Information Aggregation, Investment, and Managerial Incentives (2011)
Working Paper: Information Aggregation, Investment, and Managerial Incentives (2011)
Working Paper: Information Aggregation, Investment, and Managerial Incentives (2011)
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