Asset pricing with imperfect information

Han, J (2010) Asset pricing with imperfect information. Doctoral thesis, University of London: London Business School.

Abstract

mperfect information of the participants in financial markets has been regarded as one of the important frictions which form the equilibrium in financial markets. At the heart of the discussions regarding information-related frictions, there lies the revelation of private information through the price system. Early literature such as Milgrom and Stokey (1982) shows that there would be no trade in financial markets unless there exist some noises which prevent the full revelation of private information. Therefore, a financial model with imperfect information typically involves the existence of noise in the trading volume which may stem from liquidity shock, investor sentiment, or any other factors unrelated to fundamentals of traded assets. Such a concept has been elegantly modeled as noisy rational expectation equilibrium models in Walrasian auctions (e.g., Grossman and Stiglitz (1980)) or market maker models (e.g., Kyle (1985)). A large volume of literature has been developed by building on these canonical frameworks of financial equilibrium with imperfect information, and these frameworks have shed light on many economic problems in financial markets. The history of financial markets including the recent turmoils in financial markets has shown the fragility as well as the tendency of instability of financial markets. The canonical models, however, generally do not generate any instability due to its stabilizing force even in the presence of noises in the trading volume. I argue that it is because some of the important aspects regarding the source of the frictions are taken as given or assumed away for the simplicity of analysis. In this thesis, I attempt to verify how financial equilibrium can be easily distorted from the ones resulting from the canonical setups if some of the existing assumptions are relaxed. In particular, I study various new aspects of financial instability with imperfect information by examining the source of information-related frictions such as learning ability, information acquisition and noise trading. To achieve this goal, I first start my analysis by reviewing the existing models of financial markets as benchmark models. Chapter 2 studies two canonical frameworks in financial equilibrium with imperfect information: (i) Grossman and Stiglitz model, (ii) Kyle model. In this chapter, I explain a unifying framework which incorporates both types of models, and compare the equilibrium properties of these two types of models. Traditional models of informed trading typically assume the existence of noise trading activities which generate pure random noise in trading volumes. Chapter 3 studies a multi-period model of speculative trading in the presence of a systematic component of the noise trading activities which is privately observed by a monopolistic risk-averse informed trader. Because of the incentive to hide the magnitude of informed trading, the informed trader's trades may comove with the mispricing caused by the systematic component of noise trading instead of engaging in arbitrage. The result implies that an arbitrageur who has superior information on non-fundamentals such as investor sentiment may not always reduce the mispricing caused by them given private information on fundamentals. The result demonstrates that market manipulation could easily occur in a standard Kyle model with relatively mild assumptions if private information has more than two dimensions including nonfundamental factors. Chapter 4 develops a model of self-reinforcing financial fads in which traders' observational learning is constrained by partitions (or discrete categories). The traders only understand average behavior of prices over the partitions, but they are fully aware of such limitations. I assume that the partitions of the informed traders are finer than those of the uninformed traders. The informed traders may simultaneously shift their trading strategies depending on the arrival of certain price paths while the uninformed traders only recognize the possibility of such events. Unable to know the exact shift in the informed traders' strategies, the uninformed traders excessively extrapolate past returns. Consequently, feedback loops of price changes emerge because the uninformed traders' positive feedback trading gets amplified by its own feedback effects over time. Bubble-like price patterns arise intermittently due to feedback loops of price changes. Chapter 5 studies a finite-horizon overlapping generations model where agents endogenously acquire information on a risky asset of which fundamental value uctuates due to new fundamental shocks. Since the short-lived agents can not carry the asset until the liquidation of the long-lived risky asset, an early generation of agents does not engage in costly information acquisition unless the later generations engage in information acquisition consecutively until the liquidation like a chain. The result shows that fundamental shocks of high magnitude in the future may eliminate the incentive of acquiring information in the earlier periods, thereby breaking the 'information acquisition chain' from the earliest generation. Therefore, I explain in which circumstances the prices reflect available information slowly.