The Journal of Finance

Arbitrage Chains

Published: 07/01/1994   |   DOI: 10.1111/j.1540-6261.1994.tb00080.x

JAMES DOW, GARY GORTON

A privately informed trader will engage in costly arbitrage, that is, trade on his knowledge that the price of an asset is different from the fundamental value if: (1) his order does not move the price immediately to reflect the information; and (2) he can hold the asset until the date when the information is reflected in the price. We study a general equilibrium model in which all agents optimize. In each period, there may be a trader with a limited horizon who has private information about a distant event. Whether he acts on his information, and whether subsequent informed traders act, is shown to depend on the possibility of a sequence or chain of future informed traders spanning the event date. An arbitrageur who receives good news will buy only if it is likely that, at the end of his trading horizon, a subsequent arbitrageur's buying will have pushed up the expected price. We show that limited trading horizons result in inefficient prices, because informed traders do not act on their information until the event date is sufficiently close. We also show that limited horizons can arise because of the cost‐carry associated with holding an arbitrage portfolio over an extended period of time.

Stock Market Efficiency and Economic Efficiency: Is There a Connection?

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb02726.x

JAMES DOW, GARY GORTON

In a capitalist economy, prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most “informationally efficient” prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. However, because this role is only indirect, the link between price efficiency and economic efficiency is tenuous. We show that stock price efficiency is not sufficient for economic efficiency by showing that the model may have another equilibrium in which prices are strong‐form efficient, but investment decisions are suboptimal. We also suggest that stock market efficiency is not necessary for investment efficiency by considering a banking system that can serve as an alternative institution for the efficient allocation of investment resources.

Financial Intermediaries and Liquidity Creation

Published: 03/01/1990   |   DOI: 10.1111/j.1540-6261.1990.tb05080.x

GARY GORTON, GEORGE PENNACCHI

Trading losses associated with information asymmetries can be mitigated by designing securities which split the cash flows of underlying assets. These securities, which can arise endogenously, have values that do not depend on the information known only to informed agents. Bank debt (deposits) is an example of this type of liquid security which protect relatively uninformed agents, and we provide a rationale for deposit insurance in this content. High‐grade corporate debt and government bonds are other examples, implying that a money market mutual fund‐based payments system may be an alternative to one based on insured bank deposits.

Corporate Control, Portfolio Choice, and the Decline of Banking

Published: 12/01/1995   |   DOI: 10.1111/j.1540-6261.1995.tb05183.x

GARY GORTON, RICHARD ROSEN

In the 1980s, U.S. banks became systematically less profitable and riskier as nonbank competition eroded the profitability of banks' traditional activities. Bank failures rose exponentially during this decade. The leading explanation for the persistence of these trends centers on fixed‐rate deposit insurance: the insurance gives bank equityholders an incentive to take on risk when the value of bank charters falls. We propose and test an alternative explanation based on corporate control considerations. We show that managerial entrenchment played a more important role than did the moral hazard associated with deposit insurance in explaining the recent behavior of the banking industry.

Eat or Be Eaten: A Theory of Mergers and Firm Size

Published: 05/20/2009   |   DOI: 10.1111/j.1540-6261.2009.01465.x

GARY GORTON, MATTHIAS KAHL, RICHARD J. ROSEN

We propose a theory of mergers that combines managerial merger motives with an industry‐level regime shift that may lead to value‐increasing merger opportunities. Anticipation of these merger opportunities can lead to defensive acquisitions, where managers acquire other firms to avoid losing private benefits if their firms are acquired, or “positioning” acquisitions, where firms position themselves as more attractive takeover targets to earn takeover premia. The identity of acquirers and targets and the profitability of acquisitions depend on the distribution of firm sizes within an industry, among other factors. We find empirical support for some unique predictions of our theory.