Price Volatility and Investor Behavior in an Overlapping-Generations Model With Information Asymmetry

Abstract

This paper studies an overlapping-generations model with multiple securities and heterogeneously informed agents. The model produces multiple equilibria, including highly volatile equilibria that can exhibit strong or weak correlations between asset returns--even when asset supplies and future dividends are uncorrelated across assets. Less informed agents rationally behave like trend-followers, while better informed agents follow contrarian strategies. Trading volume has a hump-shaped relation with information precision and is positively correlated with absolute price changes. Accurate information increases the stock-return volatility and correlation in the highly volatile, strongly correlated equilibrium.

Keywords: overlapping generations, noisy rational expectations equilibrium, excessive volatility, comovement, trend-following behavior, contrarians

JEL Classification: G12, G14