Journal Article

Manipulation and the Allocational Role of Prices

Itay Goldstein and Alexander Guembel

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 75, issue 1, pages 133-164
Published in print January 2008 | ISSN: 0034-6527
Published online January 2008 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2007.00467.x
Manipulation and the Allocational Role of Prices

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It is commonly believed that prices in secondary financial markets play an important allocational role because they contain information that facilitates the efficient allocation of resources. This paper identifies a limitation inherent in this role of prices. It shows that the presence of a feedback effect from the financial market to the real value of a firm creates an incentive for an uninformed trader to sell the firm's stock. When this happens the informativeness of the stock price decreases, and the beneficial allocational role of the financial market weakens. The trader profits from this trading strategy, partly because his trading distorts the firm's investment. We therefore refer to this strategy as manipulation. We show that trading without information is profitable only with sell orders, driving a wedge between the allocational implications of buyer and seller initiated speculation, and providing justification for restrictions on short sales.

Keywords: G14; G31; G32

Journal Article.  21031 words.  Illustrated.

Subjects: Economics ; Corporate Governance

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