Information and the Equity Premium

Abstract

We consider the effect of information on the ex ante average risk-free rate and the equity premium in a standard exchange economy with a representative agent. We show that information always increases the average risk-free rate. Clearly, perfect information eliminates the equity premium; moreover, we show that a particular kind of information about the level of the return to equity always decreases the average equity premium. Surprisingly, however, information must sometimes raise the ex ante premium, no matter what the preferences of the representative agent; and information purey about the volatility of the return always raises the equity premium for a interesting class of preferences. We consider two different economies: a two-period model with arbitrary preferences for the representative agent; and an infinite horizon model with additive separable CES utility with independent growth rates.

Keywords: Information, Asset Prices, Risk-Free Rate, Equity Premium

JEL Classification: D8, D9, G12