Moral Hazard, Informed Trading, and Stock Prices

Abstract

We analyze a dynamic model of informed trading where a shareholder accumulates shares in an anonymous market and then expends costly effort to change the firm value. We find that equilibrium prices are affected by the position accumulated by the shareholder, because the level of effort undertaken is increasing in the size of his acquired position. In equilibrium, price impact has two components: one due to asymmetric information (as in Kyle (1985)) and one due to moral hazard (a new source of adverse selection). Price impact is higher when the activist is more productive and when uncertainty about his position is large. When we consider an 'activist' shareholder --- who accumulates shares in order to increase firm value --- we obtain a trade-off: with more noise trading (less 'price efficiency') the activist can build up a larger stake, which leads to more effort expenditure and higher firm value (more 'economic efficiency'). The model implies that activist ownership disclosure tends to improve market liquidity and value creation by activists and helps differentiate productive activists from stock pickers. Shortening the period during which activists can trade, however, hurts economic efficiency.