Liquidity and asset prices in rational expectations equilibrium with ambiguous information

Ozsoylev, Han and Werner, Jan (2011) Liquidity and asset prices in rational expectations equilibrium with ambiguous information. Economic Theory, 48 (2). pp. 469-491.

Abstract

The quality of information in financial asset markets is often hard to estimate. This paper analyzes information transmission in asset markets when agents treat information of unknown quality as ambiguous. We consider a market with risk-averse informed investors, risk-neutral competitive arbitrageurs, and noisy supply of the risky asset, first studied in Vives (1995a,b) with unambiguous information. Ambiguous information gives rise to the possibility of illiquid market where arbitrageurs choose not to trade in a rational expectations equilibrium. When market is illiquid, small informational or supply shocks have relatively large effects on asset prices. We show that trading volume decreases and liquidity risk increases with ambiguity about probability distribution of asset payoffs. High ambiguity may lead to excess volatility of asset prices.

Item Type: Article
Keywords: Ambiguit; Asymmetric information; Liquidity; Rational expectations equilibrium
Subject(s): Finance
Centre: Faculty of Finance
Date Deposited: 17 Nov 2011 17:54
Last Modified: 23 Oct 2015 14:06
URI: http://eureka.sbs.ox.ac.uk/id/eprint/1167

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