Asymmetric Information in Financial Markets: Anything Goes

Abstract:     
I study a standard Grossman and Stiglitz (1980) noisy rational expectations economy, but relax the usual assumption of the normality of fundamental and supply. My solution approach dispenses with the typical "conjecture and verify" method and enables me to analytically solve an entire class of previously intractable nonlinear models that nests the standard model. I show how: (1) price jumps and crashes may arise endogenously, purely due to learning effects, (2) observation of the net trading volume of informed and noise traders may be valuable for investors in the economy as it can provide a refinement of the information conveyed by price, (3) the value of acquiring information may be non-monotonic in the number of informed traders, leading to multiple equilibria in the information market, and (4) the relation between disagreement and future returns is ambiguous. In short, many of the results from noisy rational expectations models are not robust. Finally, I introduce monotone likelihood ratio conditions that determine the signs of the various comparative statics, which represents the first demonstration of the importance of the MLRP for comparative statics in this literature.

Number of Pages in PDF File: 49

Keywords: Asymmetric Information, Noisy Rational Expectations, Strategic Complementarity, Crashes

JEL Classification: D82, G14

working papers series