Commitment to Overinvest and Price Informativeness

Alexander Guembel, James Dow, London Business School, Itay Goldstein, Wharton School and University of Pennsylvaniaor|1|paper_authors_othe

No 2005-FE-18, Economics Series Working Papers from University of Oxford, Department of Economics

Abstract: A fundamental role of financial markets is to gather information on firms` investment opportunities, and so help guide investment decisions in the real sector. We argue in this paper that firms` overinvestment is something necessary to induce speculators in financial markets to produce information. If firms always cancel planned investments following poor stock market response, the value of their shares will become insensitive to information on investment opportunities, so that speculators will be deterred from producing information. We discuss several commitment devices firms can use to facilitate information production. We show that the mechanism studied in the paper amplifies shocks to fundamentals across stages of the business cycle.

Date: 2005-11-01
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