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Title: A Theory of Asset Prices based on Heterogeneous Information

Author(s): Elias Albagli, Christian Hellwig and Aleh Tsyvinski

Publication Date: January 2013

Keyword(s): asset prices, information aggregation, Modigliani-Miller Theorem and skewness

Programme Area(s): Financial Economics and International Macroeconomics

Abstract: With only minimal restrictions on security payoffs and trader preferences, noisy aggregation of heterogeneous information drives a systematic wedge between the impact of fundamentals on the price of a security, and the corresponding impact on cash flow expectations. From an ex ante perspective, this information aggregation wedge leads to a systematic gap between an asset's expected price and its expected dividend. The sign and magnitude of this expected wedge depend on the asymmetry between upside and downside payoff risks and on the importance of information heterogeneity. We consider three applications of our theory. We first show that predictions of our model provide a novel theoretical justification and are quantitatively consistent with documented empirical regularities on negative relationship between returns and skewness. Second, we illustrate how heterogeneous information leads to systematic departures from the Modigliani-Miller theorem and provide a new theory of debt versus equity. Third, we provide conditions under which permanent over- or under-pricing of assets is sustainable in a dynamic version of our model.

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Bibliographic Reference

Albagli, E, Hellwig, C and Tsyvinski, A. 2013. 'A Theory of Asset Prices based on Heterogeneous Information'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9291