COWLES FOUNDATION FOR RESEARCH IN
ECONOMICS Box 208281
COWLES FOUNDATION DISCUSSION PAPER NO. 1816 Information Aggregation, Investment, and Managerial Incentives Elias Albagli, Christian Hellwig, and Aleh Tsyvinski August 2011 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. |
