A theory of asset prices based on heterogeneous information

We propose a theory of asset prices that emphasizes heterogeneous information as the main element determining prices of different securities. 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 an asset price, 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, whose sign and magnitude depend on the asymmetry between upside and downside payoff risks, and on the importance of information heterogeneity. Moreover, when information frictions are sufficiently severe, the model is consistent with arbitrarily high levels of excess price variability as well as low return predictability. Importantly, these results do not rely on traders' risk aversion and thus offer an alternative theory of expected asset returns and price volatility. As applications of our theory, we first highlight how heterogeneous information leads to systematic departures from the Modigliani-Miller theorem and provide a new theory of debt versus equity. Second, in a dynamic extension we provide conditions under which price bubbles are sustainable.