Discontinuous Feedback Effects in Asset Pricing

Abstract: We study a manager with discretion who can potentially enhance the firm value by exerting privately costly effort. We show that anonymous trade of shares of such a firm creates discontinuous and powerful feedback effects which in turn result in substantial asset pricing distortions. We show that in this setting there is a unique critical price where the manager’s optimal ownership drops discontinuously. At this price the firm value drops from a value strictly above market price to a value strictly below it. Powerful market forces drive the trade price towards this value-discontinuity. We investigate this structure for a risk neutral and then for a risk averse manager and show that in both setups the agency problem cannot be priced in correctly, i.e. the firm’s value systematically differs from its market price. Von Lilienfeld-Toal and Ruenzi (2014) confirm empirically the here predicted price distortions.