A Theory of Asset Prices Based on Heterogeneous Information

Elias Albagli, Christian Hellwig and Aleh Tsyvinski
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Elias Albagli: USC Marshall

No 1827, Cowles Foundation Discussion Papers from Cowles Foundation for Research in Economics, Yale University

Abstract: We propose a theory of asset prices that emphasizes heterogeneous information as the main element determining prices of different securities. Our main analytical innovation is in formulating a model of noisy information aggregation through asset prices, which is parsimonious and tractable, yet flexible in the specification of cash flow risks. We show that the noisy aggregation of heterogeneous investor beliefs drives a systematic wedge between the impact of fundamentals on an asset price, and the corresponding impact on cash flow expectations. The key intuition behind the wedge is that the identity of the marginal trader has to shift for different realization of the underlying shocks to satisfy the market-clearing condition. This identity shift amplifies the impact of price on the marginal trader's expectations. We derive tight characterization for both the conditional and the unconditional expected wedges. Our first main theorem shows how the sign of the expected wedge (that is, the difference between the expected price and the dividends) depends on the shape of the dividend payoff function and on the degree of informational frictions. Our second main theorem provides conditions under which the variability of prices exceeds the variability for realized dividends. We conclude with two applications of our theory. First, we highlight how heterogeneous information can lead to systematic departures from the Modigliani-Miller theorem. Second, in a dynamic extension of our model we provide conditions under which bubbles arise.

Keywords: Information aggregation; Information wedge; Heterogeneous beliefs; Modigliani-Miller theorem; Bubbles (search for similar items in EconPapers)
JEL-codes: E44 G12 G14 G30 (search for similar items in EconPapers)
Pages: 43 pages
Date: 2011-10
New Economics Papers: this item is included in nep-cba, nep-cis and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Related works:
Working Paper: A Theory of Asset Prices based on Heterogeneous Information (2013)
Working Paper: A Theory of Asset Prices Based on Heterogeneous Information (2012)
Working Paper: A theory of asset prices based on heterogeneous information (2012)
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