Influencing Limits to Arbitrage: Corporate Disclosure in Inefficient Markets

Abstract

Much of the work in behavioral corporate finance has been dedicated to analyzing how firms respond to limits to arbitrage in setting corporate policy. In this paper, we provide a theory of corporate disclosure that seeks to emphasize the existence of an alternate direction of causality: that when operating amongst noise traders, firms may set corporate policy with a mind to influence the limits to arbitrage. By controlling the amount of information arbitrageurs have on firm value, managers can affect the severity of the limits to arbitrage. As the information possessed by arbitrageurs decreases, they will be less willing to take large positions against noise trader demand, and hence, firm prices will less closely track their fundamental value. We show that this effect can lead to an equilibrium level of disclosure that is not fully revealing, and that is decreasing in the level of noise trader sentiment. In this equilibrium, in periods of high sentiment, managers will attempt to increase the effect of noise traders on stock price by decreasing the level of corporate disclosure, which will, in turn, serve to exacerbate market mispricing. In addition, we examine the benefits of disclosure regulation and show that there are important interactions between mandatory disclosure requirements and discretionary disclosure choices, which serve to greatly increase the benefit of disclosure regulation in an inefficient market.