Survey_KP_2020

Abstract

We present a model in which risk-averse arbitrageurs can advertise their private information about mispriced assets to rational investors with limited attention, and at the same time choose their portfolios to exploit the price correction induced by such advertising. Under the convenient assumptions of constant-absolute risk aversion (CARA) and normal fundamentals and noise trading, we show that insofar as advertising succeeds in overcoming the limited attention of rational investors, it reduces the risk incurred by the arbitrageur in liquidating his position. This risk arises either from noise traders or from independent public news that pushes the price away from the arbitrageur’s private information. This risk reduction in turn enhances the arbitrageur’s willingness to make large bets on his private information, engendering a complementarity between advertising and portfolio bias towards the securities advertised. Owing to the interaction between these two choices, the model yields a number of predictions about advertising activity, arbitrageurs’ portfolio choices and equilibrium prices, some consistent with the evidence provided by recent studies and others still to be tested. Our model spans two strands of research: the literature on limited attention in asset markets, which studies portfolio choice and asset pricing when investors cannot process all the relevant information (Barber and Odean (2008), DellaVigna and Pollet (2009), Huberman and Regev (2001), Peng and Xiong (2006), and Van Nieuwerburgh and Veldkamp (2009, 2)), and that on the limits to arbitrage and its inability to eliminate all mispricing (see Shleifer and Vishny (1997) and Gromb and Vayanos (2), among others). In our setting, investors’ limited attention is the reason for advertising, which succeeds precisely when it catches the attention of investors, i.e. when it induces them to devote their limited processing capacity to the opportunity identified.5 Advertising also adds a dimension that is lacking in the limits-to-arbitrage models: it enables arbitrageurs to effectively relax those limits and endogenously speed up the movement of capital towards arbitrage opportunities.