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Asset pricing with random information flow

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  • Dorje C. Brody
  • Yan Tai Law

Abstract

In the information-based approach to asset pricing the market filtration is modelled explicitly as a superposition of signals concerning relevant market factors and independent noise. The rate at which the signal is revealed to the market then determines the overall magnitude of asset volatility. By letting this information flow rate random, we obtain an elementary stochastic volatility model within the information-based approach. Such an extension is economically justified on account of the fact that in real markets information flow rates are rarely measurable. Effects of having a random information flow rate is investigated in detail in the context of a simple model setup. Specifically, the price process of the asset is derived, and its characteristic behaviours are revealed via simulation studies. The price of a European-style option is worked out, showing that the model has a sufficient flexibility to fit volatility surface. As an extension of the random information flow model, price manipulation is considered. A simple model is used to show how the skewness of the manipulated and unmanipulated price processes take opposite signature.

Suggested Citation

  • Dorje C. Brody & Yan Tai Law, 2010. "Asset pricing with random information flow," Papers 1009.3810, arXiv.org.
    • Handle: RePEc:arx:papers:1009.3810
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    File URL: http://arxiv.org/pdf/1009.3810
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