Information Percolation Driving Volatility

56 Pages Posted: 16 Mar 2012

See all articles by Daniel Andrei

Daniel Andrei

McGill University; Desautels Faculty of Management

Date Written: March 9, 2012

Abstract

Sudden big price changes are followed by periods of high and persistent volatility. I develop a tractable dynamic rational expectations model consistent with this observation. An infinity of agents possess dispersed information about future dividends and trade in centralized markets. Information is processed, transmitted, and aggregated in two ways: (i) agents meet randomly and exchange information through word-of-mouth communication, and (ii) the price aggregates information through the trading process. Both mechanisms operate simultaneously to generate high and persistent volatility. The resulting information flow drives both returns and volume. The short-term asset, defined as the claim to immediate future dividends, becomes more volatile. The pronounced heterogeneity in investors’ information endowments induces patterns of trade consistent with empirical findings. These results serve as a road sign indicating the central role played by word-of-mouth communication in financial markets.

Keywords: dynamic equilibrium, overlapping generations, volatility clustering, GARCH, information percolation, word-of-mouth, noisy rational expectations, centralized markets

JEL Classification: D51, D53, D82, D83, G11, G12

Suggested Citation

Andrei, Daniel, Information Percolation Driving Volatility (March 9, 2012). Available at SSRN: https://ssrn.com/abstract=2022967 or http://dx.doi.org/10.2139/ssrn.2022967

Daniel Andrei (Contact Author)

McGill University ( email )

1001 Sherbrooke St. W
Montreal, Quebec H3A 1G5
Canada

Desautels Faculty of Management ( email )

1001 Sherbrooke St. W
Montreal, Quebec H3A 1G5
Canada

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