Excess Returns and the Distinguished Player Paradox

Suppose the value of a ¯rm is endogenously determined by a manager\'s costly e®ort. We call this manager a distinguished player if he also can trade shares of the ¯rm on a market. Arbitrage-free asset pricing theory suggests that the equilibrium market price re°ects the value increasing contribution of a distinguished player. Trade at this price, however, cannot be an equilibrium of a market game since due to private e®ort costs, shares have a lower value to the distinguished player as compared to other investors. Why? The distinguished player himself can gain by selling at this price and in turn reduce e®ort. By merging asset pricing and corporate ¯nance concepts we solve this distinguished player paradox and show how this asymmetry in valuations can systematically bring about a trade price strictly below the equilibrium value of the company. This implies that buyers enjoy excess returns on their investment and is thereby at odds with the e±cient markets hypothesis. It further involves a substantial reinterpretation of traditional no-arbitrage towards a game-theoretic understanding. The empirical prediction that companies with a distinguished player yield excess-returns was con¯rmed for the sample of S&P500 ¯rms and S&P1500 ¯rms in a companion paper by von Lilienfeld-Toal and RÄunzi (2007). Our results are shown to be robust with respect to trading rules, discrete versus continuous e®ort, trading costs, noise traders, and price taking behavior.