Published on All About Finance

The informational role of stock prices

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In both high-income and developing countries, firms’ long-term funding via equity financing plays a smaller role than bond issuances and syndicated loans (Cortina et al., 2015). However, developed and liquid stock markets are expected to play a key role by aggregating information about economic activity and firms’ fundamentals; information that in turn might be useful for firms’ managers, capital providers and regulatory authorities. In this sense, stock prices are expected to improve efficiency by directing capital towards more productive uses. For example, stock prices might facilitate firms’ access to credit by reducing information asymmetries between capital providers and firms, or alternatively, the stock price of a company might be informative to the manager when making a real investment decision.

Despite years of efforts to promote equity markets in developing countries, many of these markets are still small and display little trading volume. Moreover, as documented by several studies (e.g. Morck et al., 2000) the information content of stock prices in these markets tends to be low relative to stock markets in countries with well-developed financial systems.

In a recent paper, I study information aggregation in stock prices when firm managers have different quality of information about the outlook of their real investment opportunities. The paper highlights a fundamental limitation to the informational role of stock prices. In a model with learning from prices and strategic trading, I show that private information is not fully incorporated into stock prices when firms have low quality of managerial information. This happens despite the fact that some traders in secondary markets are endowed with perfect information. Overall, stock prices provide useful signals when managers are well informed a priori, but fail to guide investment when firms have low quality of managerial information.

I test model predictions using a sample of U.S. publicly traded companies. The evidence suggests a positive correlation between the quality of managers' information and stock price informativeness. Moreover, I find that the relation between managerial information and the sensitivity of investment to stock prices follows an inverse U-shape pattern, a feature that is uniquely predicted by the model. The main lesson is that information in stock prices is only complementary to the firm, and cannot substitute managerial information.

The implications for capital market development are twofold. First, if idiosyncratic risks are compounded by additional aggregate uncertainty from institutional and policy weaknesses, stock markets are likely to provide little informational value to real decision makers. While policy makers should continue to focus on strengthening the legal and institutional frameworks, alternative investment vehicles might be viable tools to overcome market failures. For example, under uncertainty, investors with information might find optimal to take a Private Equity (PE) position in the investee firm, which would allow them a direct participation in the firm corporate decisions. In this sense, the leading role of the International Finance Corporation (IFC) as the largest PE investor in developing countries might help to circumvent fundamental limitations to the role of stock markets in these countries.

Second, to the extent that the information aggregated in stock prices is complementary to managerial information, strong reporting standards for publicly traded companies is likely to attract informed trading in secondary markets. In this case, stock prices are more likely to aggregate information and provide reliable signals for firm managers and other agents, in turn improving capital allocation and overall economic efficiency.

For further reading see: Pedraza Morales, Alvaro, 2014. “Strategic Information Revelation and Capital Allocation.” World Bank Policy Research Working Paper No. 6995


Cortina, Juan Jose, Tatiana Didier, and Sergio Schmukler, 2015. “How Long is the Financing in Corporate Bond and Syndicated Loan Markets?” Working Paper.

Morck, Randall, Bernard Yeung, and Wayne Yu, 2000. “The Information Content of Stock Markets: Why Do Emerging Markets have Synchronous Stock Price Movements?” Journal of Financial Economics 58 (1): 215-260


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