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Indiana University Bloomington

Department of Finance

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Research and Publications

Journal Articles

Costly Trading, Managerial Myopia, and Long-Term Investment

2009, Journal of Empirical Finance

Craig W. Holden, Leonard L. Lundstrum

Abstract

The costly trade theory predicts that it is much more difficult to exploit long-term private information than short-term. Thus, there is less long-term information impounded in prices. The managerial myopia theory predicts that a variety of short-term pressures, including inadequate information on long-term projects, cause asymmetrically-informed corporate managers to underinvest in long-term projects. The introduction of long-term options called LEAPS provides
a natural experiment to jointly test both theories, which are otherwise difficult to test. We conduct an event study around the introduction of LEAPS for a given stock and test whether corporate investment in long-term R&D/sales increases in the years following the introduction. We find that over a two year period of time LEAPS firms increase their R&D/sales between 23% and 28% ($125–$152 million annually) compared to matching non-LEAPS firms. The difference
depends on the matching technique used. Two other proxies for long-term investment find similar increases. We find that the increase is positively related to LEAPS volume. We also find that the increase is larger in firms where R&D plays a larger and more strategic role.We test if a firm becomes less likely to beat analyst's quarterly earnings forecasts after LEAPS are introduced and find support for the hypothesis. These results provide both statistically and economically
significant support for the costly trade and managerial myopia theories.

Citation

Holden, Craig W. and Leonard L. Lundstrum (2009), “Costly Trading, Managerial Myopia, and Long-Term Investment,” Journal of Empirical Finance, Vol. 16, pp. 126-135.

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