Information Quality and Stock Returns Revisited

Abstract

Building on the seminal work of Veronesi (2000), we investigate the relationship between the quality of information on the state of the economy and equity risk premium. In this, we use a setup where investors have Epstein-Zin preferences and the economy switches between booms and recessions at random intervals (Hamilton, 1989). Calibrating the model to fit the business cycle patterns in the US postwar data, we are able to establish two key results: First, as conjectured in the existing literature, we demonstrate that investors with high intertemporal elasticity of substitution will require lower excess returns for holding stocks if they are provided with better information on the state of the economy. Second, and even more interesting (since not predicted in the literature), we find that this will also hold for investors with a moderate elasticity of intertemporal substitution if they are moderately risk averse. * We thank Sergio Albeverio, Carlo Savino, and Pietro Veronesi for helpful comments. We also thank seminar participants at IAM, University of Bonn and at the University of St. Gallen.

Information Quality and Long‐Run Risk: Asset Pricing Implications

“…The relationship between information quality and the equity premium has been studied by Veronesi (2000), Brennan and Xia (2001), and Brevik and D'Addona (2007), among others, in pure exchange economies. In pure exchange economies with CRRA utility, Veronesi (2000) establishes the result that learning leads to a lower (higher) equity premium if RRA is higher (lower) than one, which is the opposite of my result in equation (52).…”

“…More recently, Brennan and Xia (2001) emphasize the role of learning in understanding the volatility of the stock market and the equity premium. Brevik and D'Addona (2007) study the relationship between information quality and the equity premium in a pure exchange economy with recursive preferences. Gollier and Schlee (2006) provide general conditions under which information increases or decreases the equity premium in pure exchange economies with general expected utility functions.…”

Asset pricing and the role of macroeconomic volatility

“…to be less than 1. When the elasticity of intertemporal substitution (EIS) is larger than 1, this implies a higher RA parameter relative to the inverse of the EIS, or a preference for early resolution of uncertainty, in the language of Kocherlakota, 1990. It is important to note that an EIS larger than 1, implies procyclical prices (see Brevik and d'Addona (2010)). Thus, in order to have a positive contribution by the variance of prices to the equity premium we need an agent with a preference for the early resolution of uncertainty coupled with procyclical prices.…”

“…Even if the log-linearization does not strictly hold for our non-linear economy, the implications that follow are valuable.10 For a detailed loglinear analysis in a similar framework seeBrevik and d'Addona (2010).…”

The behavior of individual and aggregate stock prices

“…While a detailed analysis is beyond the scope of this paper, some recent progress is suggestive. Brevik and dć6Addona [13] analyze a model with one stock and a recursive preference, and show that both risk aversion and EIS affect the risk premium.…”