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E-MailAlex Edmans is Professor of Finance at London Business School. This post is based on an article authored by Professor Edmans and Sudarshan Jayaraman, Associate Professor of Accounting at the University of Rochester.
In our paper, The Source of Information in Prices and Investment-Price Sensitivity, which was recently made publicly available on SSRN, we show that real decisions depend not only on the total amount of information in prices, but the source of this information—a manager learns from prices when they contain information not possessed by him.
Our research is related to a literature on The Real Effects of Financial Markets, which shows that efficient financial markets can promote efficient real decisions. When prices are more informative, outside investors suffer less information asymmetry. As a result, they are more willing to provide capital to firms in primary financial markets, facilitating investment. Under this channel, the extent to which financial markets support capital raising, and thus real investment, depends on the total amount of information in prices. In a recent survey, Bond, Edmans, and Goldstein (2012) term this notion Forecasting Price Efficiency (“FPE”), i.e. the extent to which prices predict fundamental values. Due to this conventional view, regulatory changes (e.g. short-sale constraints and transaction taxes) are evaluated according to their likely impact on total price informativeness.
However, Bond et al. (2012) note that the most activity occurs in secondary financial markets, where no new capital is raised by firms. Secondary markets improve real decisions through a different channel: they aggregate the information of millions of investors (Hayek (1945)), which can guide managerial actions. The value of secondary markets for real decisions depends not on total information in prices (FPE), but the amount of information prices reveal for decision-making—i.e., the amount of information not already possessed by the decision maker. They term this notion Revelatory Price Efficiency (“RPE”) and propose it as a new measure of financial efficiency. However, RPE has no natural empirical proxy, making it difficult to study empirically.
Our goal is to study whether real decisions depend on RPE, and thus the source of information in prices, rather than only total information (FPE). This question is important, because if RPE indeed matters, standard measures of financial efficiency are not sufficient for gauging real efficiency. We study this question in the context of investment, a major corporate decision. Specifically, we hypothesize that the manager uses the stock price as a signal of his investment opportunities. Thus, the sensitivity of investment to Tobin’s Q will be increasing in the amount of information in prices not possessed by the manager.
We address the absence of a natural measure for RPE by studying a plausible shock to RPE that is unlikely to affect FPE. Such a shock should satisfy three criteria. First, it should increase the amount of outsider information in the stock price, by reducing outsiders’ incentives to either acquire and/or trade on information. Second, it should not change (or at least not increase) total information, i.e. FPE. To satisfy both criteria simultaneously, the event must also decrease the amount of insider information in the stock price, so that it changes only the source of information, and not the total amount. Satisfying both criteria is difficult, since commonly-used shocks to the information environment (e.g. decimalization) affect both insiders’ and outsiders’ ability to trade. Third, it should not affect investment-Q sensitivity directly, but only through its effect on RPE.
We study how investment-Q sensitivity is affected by the first-time enforcement of insider trading laws. Insider trading enforcement (“ITE”) deters insiders from trading, and thus encourages outsiders to do so (Fishman and Hagerty (1992)). Bushman, Piotroski, and Smith (2005) find that analyst coverage rises after ITE, particularly in emerging markets, and Fernandes and Ferreira (2009) find that total price informativeness is unchanged following ITE in emerging markets (while it rises in developed markets). Thus, ITE plausibly increases the information in prices not possessed by the manager (RPE) without affecting total information (FPE), at least in emerging markets. A separate advantage is that ITE was staggered over time across 26 countries, reducing the risk that any single event was correlated with other factors that drive investment-Q sensitivity.
We conduct our difference-in-differences analysis using two methods. The first is a single-stage analysis, where we regress investment on Q, its interactions with ITE, other firm- and country-level determinants of investment, and firm and country-year fixed effects. Investment-Q sensitivity for enforcers rises by 33% (from 0.348 to 0.464) following ITE, significant at the 1% level. The second is a two-stage analysis, where we first estimate investment-Q sensitivity for each country-year, controlling for firm-level determinants of investment, and then regress these estimated sensitivities on ITE indicators, country controls, and country and year fixed effects. The effect of ITE remains robust.
Overall, these results suggest that it is not only the total amount of information in prices that matters for real efficiency, but the source of information in prices—whether this information is already known to the decision maker. As a result, measures of total price informativeness may be insufficient for measuring the contribution of financial markets to the efficiency of real decisions. For example, the results suggest a new cost of insider trading that is absent from prior literature. Previous research studies the effect of insider trading on total price informativeness (e.g. Manove (1989), Ausubel (1990), Fishman and Hagerty (1992), Leland (1992)), under the assumption that outsider and insider information are substitutes. However, this paper suggests that it is outsider information that matters for investment decisions. Thus, even if the decrease in outsider information in prices, that results from allowing insider trading, is offset by the increase in insider information, real efficiency may still decline.
The full paper is available for download here.
