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How Equilibrium Prices Reveal Information in Time Series Models with Disparately Informed, Competitive Traders

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  • Todd B. Walker

    ()
    (Indiana University Bloomington)

Abstract

Accommodating asymmetric information in a dynamic asset pricing model is technically challenging due to the problems associated with higher-order expectations. That is, rational investors are forced into a situation where they must forecast the forecasts of other agents. In a dynamic setting, this problem telescopes into the infinite future and the dimension of the relevant state space approaches infinity. By using the frequency domain approach of Whiteman (1983) and Kasa (2000), this paper demonstrates how information structures previously believed to preserve asymmetric information in equilibrium, converge to a symmetric information, rational expectations equilibrium. The revealing aspect of the price process lies in the invertibility of the observed state space, which makes it possible for agents to infer the economically fundamental shocks and thus eliminating the need to forecast the forecasts of others.

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File URL: http://www.iub.edu/~caepr/RePEc/PDF/2006/CAEPR2006-011.pdf
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Bibliographic Info

Paper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2006-011.

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Length: 29 pages
Date of creation: Sep 2006
Date of revision:
Handle: RePEc:inu:caeprp:2006011

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Keywords: Asset Pricing; Asymmetric Information;

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References

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  1. Marco Lippi & Lucrezia Reichlin, 1994. "VAR analysis, non-fundamental representations, Blashke matrices," ULB Institutional Repository 2013/10151, ULB -- Universite Libre de Bruxelles.
  2. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  3. Philippe Bacchetta & Eric van Wincoop, 2003. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," Working Papers 03.02, Swiss National Bank, Study Center Gerzensee.
  4. Stephen Morris & Franklin Allen & Hyun Song Shin, 2004. "Beauty Contests, Bubbles and Iterated Expectations in Asset Markets," Yale School of Management Working Papers ysm346, Yale School of Management.
  5. Futia, Carl A, 1981. "Rational Expectations in Stationary Linear Models," Econometrica, Econometric Society, vol. 49(1), pages 171-92, January.
  6. Townsend, Robert M, 1983. "Forecasting the Forecasts of Others," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 546-88, August.
  7. Joseph G. Pearlman & Thomas J. Sargent, 2005. "Knowing the Forecasts of Others," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 480-497, April.
  8. Kenneth Kasa, 1995. "Signal extraction and the propagation of business cycles," Working Papers in Applied Economic Theory 95-14, Federal Reserve Bank of San Francisco.
  9. Foster, F Douglas & Viswanathan, S, 1996. " Strategic Trading When Agents Forecast the Forecasts of Others," Journal of Finance, American Finance Association, vol. 51(4), pages 1437-78, September.
  10. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  11. Lars Peter Hansen & Thomas J. Sargent, 1979. "Formulating and estimating dynamic linear rational expectations models," Working Papers 127, Federal Reserve Bank of Minneapolis.
  12. He, Hua & Wang, Jiang, 1995. "Differential Information and Dynamic Behavior of Stock Trading Volume," Review of Financial Studies, Society for Financial Studies, vol. 8(4), pages 919-72.
  13. Michael Woodford, 2001. "Imperfect Common Knowledge and the Effects of Monetary Policy," NBER Working Papers 8673, National Bureau of Economic Research, Inc.
  14. Pearlman, Joseph & Currie, David & Levine, Paul, 1986. "Rational expectations models with partial information," Economic Modelling, Elsevier, vol. 3(2), pages 90-105, April.
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Cited by:
  1. Pengfei Wang & Yi Wen, 2007. "Incomplete information and self-fulfilling prophecies," Working Papers 2007-033, Federal Reserve Bank of St. Louis.
  2. Philippe Bacchetta & Eric Van Wincoop, 2008. "Higher Order Expectations in Asset Pricing," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 837-866, 08.

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