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Information Asymmetry, Information Precision, and the Cost of Capital

Review of Finance, 2011

Wharton Financial Institutions Center Working Paper No. 06-21

42 Pages Posted: 11 Oct 2006 Last revised: 25 Nov 2011

Richard A. Lambert

University of Pennsylvania - Accounting Department

Christian Leuz

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Center for Financial Studies (CFS); University of Pennsylvania - Wharton Financial Institutions Center; CESifo Research Network

Robert E. Verrecchia

University of Pennsylvania - Accounting Department

Multiple version iconThere are 3 versions of this paper

Date Written: March 1, 2008

Abstract

The consequences of information differences across investors in capital markets are still much debated. This paper examines the relation between information differences across investors and the cost of capital, and makes three points. First, in models of perfect competition, information differences across investors affect a firm's cost of capital through investors' average information precision, and not information asymmetry per se. Second, the average information precision effect is unlikely to diversify away when there exist many firms whose cash flows covary. Thus, better disclosure can reduce a firm's cost of capital. Third, the precision effect does not give rise to a separate information risk factor. These points are important to empirical research in financial economics, as well as to regulators who debate future disclosure requirements and the consequences of prior requirements such as Regulation Fair Disclosure.

Keywords: Information risk, Cost of capital, Expected return, Asset pricing, Disclosure, Rational expectations, Diversification

JEL Classification: G12, M41, D82

Suggested Citation

Lambert, Richard A. and Leuz, Christian and Verrecchia, Robert E., Information Asymmetry, Information Precision, and the Cost of Capital (March 1, 2008). Review of Finance, 2011; Wharton Financial Institutions Center Working Paper No. 06-21. Available at SSRN: https://ssrn.com/abstract=1113649 or http://dx.doi.org/10.2139/ssrn.1113649

Richard Lambert

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-7782 (Phone)
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Christian Leuz

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
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HOME PAGE: http://faculty.chicagobooth.edu/christian.leuz/

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
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HOME PAGE: http://www.nber.org

European Corporate Governance Institute (ECGI)

Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Center for Financial Studies (CFS) ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

University of Pennsylvania - Wharton Financial Institutions Center

3641 Locust Walk
Philadelphia, PA 19104-6218
United States

CESifo Research Network

Poschinger Str. 5
Munich, DE-81679
Germany

Robert E. Verrecchia (Contact Author)

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States
215-898-6976 (Phone)
215-573-2054 (Fax)

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