Information, Imperfect Competition, and Volatility
65 Pages Posted: 17 Jan 2016 Last revised: 30 Oct 2018
Date Written: October 28, 2018
We analyze a model of costly private-information acquisition and asset pricing under imperfect competition. We show that imperfect competition generally creates strategic complementarity in traders' information-acquisition decisions. The source of strategic complementarity is the change in the liquidity of the risky asset that arises from a change in the precision of a private signal: when a trader acquires a greater amount of private information, the liquidity of the risky asset generally increases. The increase in liquidity encourages other traders to acquire additional private information. We also show that strategic complementarity can shut down private-information acquisition, leading to significant illiquidity and volatility. This finding implies that excess return volatility can be observed in markets with low information asymmetry.
Keywords: \Imperfect competition, information production, excess volatility, information complementarity, adverse selection, exchange traded funds (ETFs)
JEL Classification: G11
Suggested Citation: Suggested Citation