Value creating stock manipulation: feedback effect of stock prices on firm value

Higher stock prices relax a firm's budget constraint by increasing the value of its stock currency and enabling it to acquire larger targets through stock swaps. Higher prices also signal improved prospects to firm managers, potentially affecting their investment decisions and firm value. This feedback from prices to firm value complicates trading decisions of large traders, since their trades are likely to move prices. They need to condition not only on how their trades affect prices, but also on how these price changes induce further price changes through their impact on firm investments. This paper identifies equilibrium trading strategies of such traders and equilibrium price setting by a market maker. The question arises whether traders have an incentive to manipulate prices to get firms to undertake certain investments. The answer is yes, as long as traders maintain some inventory in the stock they trade. Moreover, the price manipulation turns out to be value-increasing for firms. (C) 2004 Elsevier B.V. All rights reserved.