A Theory of Asset Pricing Based on Heterogeneous Information / Elias Albagli, Christian Hellwig, Aleh Tsyvinski.

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Albagli, Elias

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TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w17548.Publication details: Cambridge, Mass. National Bureau of Economic Research 2011.Description: 1 online resource: illustrations (black and white)Subject(s):

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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.

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Previous	nber w17545 How Do Informal Agreements and Renegotiation Shape Contractual Reference Points? /	nber w17546 Unconditional Convergence /	nber w17547 How Did the Recession of 2007-2009 Affect the Wealth and Retirement of the Near Retirement Age Population in the Health and Retirement Study? /	nber w17548 A Theory of Asset Pricing Based on Heterogeneous Information /	nber w17549 On the Connections between Intertemporal and Intra-temporal Trades /	nber w1755 Exchange Controls, Capital Controls, and International Financial Markets /	nber w17550 A Linder Hypothesis for Foreign Direct Investment /	Next

October 2011.

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.