Investment Horizons and Asset Prices Under Asymmetric Information

Abstract

I study a fully dynamic rational expectations economy with asymmetric information, where agents have finite investment horizons; T. Horizons affects asset prices through two key mechanisms: as T increases, 1) the age-adjusted risk aversion of the average investor falls, and 2) the risk transfer from forced liquidators into voluntary buyers drops. There are typically two equilibria: a stable equilibrium in which higher T lowers price volatility, and an unstable one with the opposite properties. Moreover, equilibria that fail to exist for low T can be recovered for high enough lifespan. Along the stable equilibrium, increasing T lowers price volatility and alleviates the uncertainty of uninformed investors. The low risk environment induces aggressive trading by the informed, which impound their knowledge into prices. Expected returns and return volatility are similar to an economy with full-information about fundamentals, even if the informed are relatively few. For short horizons, cautious trading disaggregates information from prices and the economy approaches one with no private information. Consistent with evidence of increased fund liquidations during episodes of financial distress, the results suggest that heightened volatility and uncertainty can be explained by the shortening of investor horizons in a rational economy with asymmetric information. JEL codes: E23, E32, G12, G14, G23.

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