Itay Goldstein

Price Informativeness and Investment Sensitivity to Stock Price

Stock prices and real investments are highly correlated. Previous literature has offered two main explanations for this high correlation. The first explanation relies on price being informative about investment opportunities, the second one is based on financing constraints. In this paper we empirically examine the effect of price informativeness on the sensitivity of investment to stock price. Using price non-synchronicity and PIN as measures of price informativeness, we find that the degree of informativeness is positively correlated with the sensitivity of investment to stock price. Since, according to previous literature, these measures reflect private information, the result suggests that prices perform an active role, i.e., that managers learn from stock price when making investment decisions. This result is robust to the inclusion of various control variables (such as controls for managerial information) and to changes in specification.

The Real Effects of Financial Markets

A large amount of activity in the financial sector occurs in secondary financial markets, where securities are traded among investors without capital flowing to firms. The stock market is the archetypal example, which in most developed economies captures a lot of attention and resources. Is the stock market just a sideshow or does it affect real economic activity? In this review, we discuss the potential real effects of financial markets that stem from the informational role of market prices. We review the theoretical literature and show that accounting for the feedback effect from market prices to the real economy significantly changes our understanding of the price formation process, the informativeness of the price, and speculators’ trading behavior. We make two main points. First, we argue that a new definition of price efficiency is needed to account for the extent to which prices reflect information that is useful for the efficiency of real decisions (rather than the extent to which they forecast future cash flows). Second, incorporating the feedback effect into models of financial markets can explain various market phenomena that otherwise seem puzzling. Finally, we review empirical evidence on the real effects of secondary financial markets.

Contagion of self-fulfilling financial crises due to diversification of investment portfolios

Abstract We look at two countries that have independent fundamentals, but share the same group of investors. Each country might face a self-fulfilling crisis: Agents withdrawing their investments fearing that others will. A crisis in one country reduces agents’ wealth. This makes them more averse to the strategic risk associated with the unknown behavior of other agents in the second country, increasing their incentive to withdraw their investments. Consequently, the probability of a crisis there increases. This generates a positive correlation between the returns in the two countries. Since diversification affects returns in our model, its welfare implications are non-trivial.

Should Banks' Stress Test Results Be Disclosed? An Analysis of the Costs and Benefits

Stress tests have become an important component of the supervisory toolkit. However, the extent of disclosure of stress-test results remains controversial. We argue that while stress tests uncover unique information to outsiders — because banks operate in second--best environments with multiple imperfections — there are potential endogenous costs associated with such disclosure.

Incentives for Information Production in Markets Where Prices Affect Real Investment

We analyze information production incentives for traders in financial markets, when firms condition investment decisions on information revealed through stock prices. We show that traders’ private value of information about a firm’s investment project increases with the ex ante likelihood the project will be undertaken. This generates an informational amplification effect of shocks to firm value. Information production by traders may exhibit strategic complementarities for projects that would not be undertaken in the absence of positive news from the stock market. A small decline in fundamentals can lead to a market breakdown where information production ceases, and investment and firm value collapse. Our theory sheds light on how productivity shocks are amplified over the business cycle.

Stress Tests and Information Disclosure

We study an optimal disclosure policy of a regulator that has information about banks (e.g., from conducting stress tests). In our model, disclosure can destroy risk-sharing opportunities for banks (the Hirshleifer effect). Yet, in some cases, some level of disclosure is necessary for risk sharing to occur. We provide conditions under which optimal disclosure takes a simple form (e.g., full disclosure, no disclosure, or a cutoff rule). We also show that, in some cases, optimal disclosure takes a more complicated form (e.g., multiple cutoffs or nonmonotone rules), which we characterize. We relate our results to the Bayesian persuasion literature.

Speculation and Hedging in Segmented Markets

We analyze a model in which traders have different trading opportunities and learn information from prices. The difference in trading opportunities implies that different traders may have different trading motives when trading in the same market—some trade for speculation and others for hedging—and thus they may respond to the same information in opposite directions. This implies that adding more informed traders may reduce price informativeness and therefore provides a source for learning complementarities leading to multiple equilibria and price jumps. Our model is relevant to various realistic settings and helps to understand a variety of modern financial markets.

Information Diversity and Complementarities in Trading and Information Acquisition

We analyze a model where the value of a traded security is affected by two different fundamentals, e.g., the quality of the firms technology and the demand for its products, and where there are two groups of informed traders, each one informed about a different fundamental. We analyze the interaction between the informativeness of the price about the two fundamentals and characterize when it leads to attenuation and when it leads to amplification of shocks to market efficiency. Amplification occurs because the informativeness about one fundamental reduces the uncertainty in trading on information about the other fundamental and encourages traders to trade more aggressively on such information. This effect is dominant when the informativeness of the price is relatively balanced between the two fundamentals, which implies that economies with more diverse information -- i.e., where the information is more evenly distributed between the two groups -- will exhibit positive externalities and have higher levels of overall market efficiency. Finally, we endogenize the incentives for information production and show that the above effect leads to strategic complementarities in information production.

Government Guarantees and Financial Stability

Government guarantees to financial institutions are intended to reduce the likelihood of runs and bank failures, but are also usually associated with distortions in banks’ risk taking decisions. We build a model to analyze these trade-offs based on the global-games literature and its application to bank runs. We derive several results, some of which against common wisdom. First, guarantees reduce the probability of a run, taking as given the amount of bank risk taking, but lead banks to take more risk, which in turn might lead to an increase in the probability of a run. Second, guarantees against fundamental-based failures and panic-based runs may lead to more efficiency than guarantees against panic-based runs alone. Finally, there are cases where following the introduction of guarantees banks take less risk than would be optimal.

Overconfidence and Team Coordination

We model a team in which the marginal productivity of a player increases with the effort of other players on the team. Because the effort of any player is not observable to any other player, the performance of the team is negatively affected by a free-rider problem and by a lack of effort coordination across players. We show that, in this context, the overconfidence of some players not only enhances team performance but may create a Pareto improvement at the individual level. Indeed, because an overconfident player overestimates his marginal productivity, his decision to exert effort does not require as much expected effort from other players. Knowing that this overconfident player works hard and thus increases their marginal productivity, other players work harder too. This concerted effort by all benefits the team, the rational players and, in some cases, the overconfident player, who overworks but benefits from the positive externality that other players working harder brings about. Such Pareto improvement may provide a rationale for individual overconfidence to perpetuate itself in firms and partnerships.