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Information Quality and Stock Returns Revisited

  • Brevik, Frode
  • d’Addona, Stefano

Building on Veronesi (2000), we investigate the relationship between the quality of information on the state of the economy and the equity risk premium. We analyze the driving forces of the premium in a regime-switching setup where agents have Epstein-Zin preferences, finding a remarkably rich relation between the required risk premium and the quality of information available to investors. In particular, relaxing the strict relationship between investors' elasticity of intertemporal substitution (EIS) and their degree of risk aversion (RA) embedded in a power utility function enables us to demonstrate how the required equity premium is determined by their interplay. As conjectured in the existing literature, we demonstrate that investors with a high EIS will require less excess returns for holding stocks if they are provided with better information on the state of the economy. More interestingly, and not predicted in the literature, we find that this will also hold for investors with a moderate EIS if they are sufficiently risk averse.

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Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 45 (2011)
Issue (Month): 06 (January)
Pages: 1419-1446

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Handle: RePEc:cup:jfinqa:v:45:y:2011:i:06:p:1419-1446_00
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