Information Markets and the Comovement of Asset Prices

Abstract

Traditional asset pricing models predict that covariance between prices of different assets should be lower than what we observe in the data. This model generates high covariance within a rational expectations framework by introducing markets for information about asset payoffs. When information is costly, rational investors will not buy information about all assets; they will learn about a subset. Because information production has high fixed costs, competitive producers charge more for low-demand information than for high-demand information. A price that declines in quantity makes investors want to purchase a common subset of information. If investors price many assets using a common subset of information, then a shock to one signal is passed on as a common shock to many asset prices. These common shocks to asset prices generate 'excess covariance.' The cross-sectional and time-series properties of asset price covariance are consistent with this explanation. * lveldkam@stern.nyu.edu, NYU Stern, Economics Department, 44 West 4th St., 7th floor, New York, NY 10012. Thanks to David Backus, Guido Lorenzoni, Thomas Sargent, Martin Schneider, Stijn Van Nieuwerburgh, Bernie Yeung, Gunter Strobl, and seminar participants at NYU, Rutgers, 2004 EFA meetings, Gerzensee summer symposium, and the 2004 SED meetings for helpful comments and conversations. Thanks also to Elif Sisli for her capable research assistance. JEL classification: D82, G14, G12.

Financial development and the cost of equity capital: Evidence from China

“…Further, banking development facilitates private information production because banks and other financial intermediaries (e.g., credit rating agencies) are information producers and processors for borrower firms (Ramakrishnan and Thakor, 1984). Given that information production involves large fixed costs, banking development improves the economies of scale and lowers the production cost (Diamond, 1984;Veldkamp, 2006). Lastly, with privileged access to borrowers' inside information, banks are better able to monitor borrower firms at a low cost (Diamond, 1984;Fama, 1984).…”

Time-series and cross-sectional excess comovement in stock indexes

“…Excess comovement has alternatively been interpreted as due to pure information transmission (King and Wadhwani, 1990), wealth effects (Kyle and Xiong, 2001), financial constraints (Calvo, 1999;Yuan, 2005), sunspot equilibria (Masson, 1998), the fragility of financial markets (Allen and Gale, 2000), the rebalancing activity of risk-averse agents (Fleming et al, 1998;Kodres and Pritsker, 2002), strategic trading by heterogeneously informed speculators (Pasquariello, 2007), relative real output shocks (Pavlova and Rigobon, 2007), the cost of acquiring information (Veldkamp, 2006), or investors' trading patterns (Barberis et al, 2005). Nevertheless, in spite of this abundance of explanations, no "horse race" among these competing (albeit seldom mutually exclusive) theories has yet emerged to ascertain their relevance in the data.…”

“…3 See, for example, the empirical studies by Rotemberg (1990, 1993),Karolyi and Stulz (1996),Fleming et al (1998), andBarberis et al (2005). Many theoretical models (e.g.,King and Wadhwani, 1990;Kodres and Pritsker, 2002;Veldkamp, 2006;Pasquariello, 2007) also describe contagion as a pervasive equilibrium property of a financial market.…”

Does market microstructure matter for corporate finance? Theory and evidence on seasoned equity offering decisions

“…21 See also Bayless, Loughran and Ritter (1995), Stein (1996), Lee (1997), Baker and Wurgler (2000), Baker et al (2003), and Polk and Sapienza (2009). 22 See Veldkamp (2006) for theoretical underpinning of asset price comovement, and Chen et al (2007) for the use of stock return synchronicity as an empirical measure of amount of private information in the stock price. and market returns to control for potential autocorrelation problems caused by sparse trading.…”