DP6588 Advance Information and Asset Prices
This paper provides a dynamic rational expectations equilibrium model in which investors have heterogeneous information and investment opportunities. Informed investors privately receive advance information that is useful for predicting future earnings, but is unrelated to current earnings. This information is immediately partially incorporated into stock prices. In response to good advance information, informed investors act as trend chasers and raise investments in both stocks and nontraded assets, leading them to bear more aggregate risk. This raises the expected risk premium and generates short-run momentum. Uninformed investors act as contrarians and sell stocks. When the advance information materializes in the future, excess returns fall, generating long-run reversals.