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A Theory of Asset Prices Based on Heterogeneous Information

  • Elias Albagli
  • Christian Hellwig
  • Aleh Tsyvinski

With only minimal restrictions on security payoffs and trader preferences, noisy aggregation of heterogeneous information drives a systematic wedge between the impact of fundamentals on the price of a security, and the corresponding impact on cash flow expectations. From an ex ante perspective, this information aggregation wedge leads to a systematic gap between an asset's expected price and its expected dividend. The sign and magnitude of this expected wedge depend on the asymmetry between upside and downside payoff risks and on the importance of information heterogeneity. We consider three applications of our theory. We first show that predictions of our model provide a novel theoretical justification and are quantitatively consistent with documented empirical regularities on negative relationship between returns and skewness. Second, we illustrate how heterogeneous information leads to systematic departures from the Modigliani-Miller theorem and provide a new theory of debt versus equity. Third, we provide conditions under which permanent over- or under-pricing of assets is sustainable in a dynamic version of our model.

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Paper provided by David K. Levine in its series Levine's Working Paper Archive with number 786969000000000347.

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Date of creation: 09 Jan 2012
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Handle: RePEc:cla:levarc:786969000000000347
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  1. Aleh Tsyvinski & Arijit Mukherji & Christian Hellwig, 2006. "Self-Fulfilling Currency Crises: The Role of Interest Rates," American Economic Review, American Economic Association, vol. 96(5), pages 1769-1787, December.
  2. Harrison Hong & Jeremy C. Stein, 2007. "Disagreement and the Stock Market," Journal of Economic Perspectives, American Economic Association, vol. 21(2), pages 109-128, Spring.
  3. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, vol. 92(2), pages 323-36, May.
  4. John H. Cochrane, 1992. "Explaining the Variance of Price Dividend Ratios," NBER Working Papers 3157, National Bureau of Economic Research, Inc.
  5. Kenneth D. West, 1986. "Dividend Innovations and Stock Price Volatility," NBER Working Papers 1833, National Bureau of Economic Research, Inc.
  6. Elias Albagli & Christian Hellwig & Aleh Tsyvinski, 2011. "Information Aggregation, Investment, and Managerial Incentives," NBER Working Papers 17330, National Bureau of Economic Research, Inc.
  7. LeRoy, Stephen F & Porter, Richard D, 1981. "The Present-Value Relation: Tests Based on Implied Variance Bounds," Econometrica, Econometric Society, vol. 49(3), pages 555-74, May.
  8. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
  9. Hong, Harrison & Sraer, David, 2013. "Quiet bubbles," Journal of Financial Economics, Elsevier, vol. 110(3), pages 596-606.
  10. Allen F. & Morris S. & Postlewaite A., 1993. "Finite Bubbles with Short Sale Constraints and Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 61(2), pages 206-229, December.
  11. Spiegel, Matthew, 1998. "Stock Price Volatility in a Multiple Security Overlapping Generations Model," Review of Financial Studies, Society for Financial Studies, vol. 11(2), pages 419-47.
  12. Masahiro Watanabe, 2008. "Price Volatility and Investor Behavior in an Overlapping Generations Model with Information Asymmetry," Journal of Finance, American Finance Association, vol. 63(1), pages 229-272, 02.
  13. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
  14. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, number 9780198296980, March.
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