Discussion Paper Details

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Title: Costly Interpretation of Asset Prices

Author(s): Xavier Vives and Liyan Yang

Publication Date: October 2017

Keyword(s): asset prices, disagreement, Investor sophistication, multiplicity, noise trading, trading volume and welfare

Programme Area(s): Financial Economics

Abstract: We propose a model in which investors cannot costlessly process information from asset prices. At the trading stage, investors are boundedly rational and their interpretation of prices injects noise into the price, generating a source of endogenous noise trading. Compared to the standard rational expectations equilibrium, our setup features price momentum and yields higher return volatility and excessive trading volume. In an overall equilibrium, investors optimally choose sophistication levels by balancing the benefit of beating the market against the cost of acquiring sophistication. Investors tend to over-acquire sophistication. There can exist strategic complementarity in sophistication acquisition, leading to multiple equilibria.

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Bibliographic Reference

Vives, X and Yang, L. 2017. 'Costly Interpretation of Asset Prices '. London, Centre for Economic Policy Research.