Market Liquidity and Performance Monitoring

TLDR

The study examines how stock market prices can serve as a monitor of managerial performance. The authors model the equilibrium size of the stock market based on investor preferences and the supply of long‑ and short‑term capital. The results show that stock prices embed performance information beyond profit data, informing managerial incentives, and that this informational value depends on market liquidity—concentrated ownership and integration diminish monitoring benefits, highlighting the private and social value of liquidity.

Abstract

This paper studies the value of the stock market as a monitor of managerial performance. It shows that the stock price incorporates performance information that cannot be extracted from the firm's current or future profit data. The additional information is useful for structuring managerial incentives. The amount of information contained in the stock price depends on the liquidity of the market. Concentrated ownership, by reducing market liquidity, reduces the benefits of market monitoring. Integration is associated with weakened managerial incentives and less market monitoring. This may explain why shares of divisions of a firm are rarely traded. The model offers a reason why market liquidity and monitoring have both a private and a social value, a feature missing in standard finance models. This is used to study the equilibrium size of the stock market as a function of investor preferences and the available amounts of long- and short-term capital.