Abstract
The quality of information in financial asset markets is often hard to estimate. Reminiscent of the famous Ellsberg paradox, investors may be unable to form a single probability belief about asset returns conditional on information signals and may act on the basis of ambiguous (or multiple) probability beliefs. This paper analyzes information transmission in asset markets when agents’ information is ambiguous. We consider a market with risk-averse informed investors, risk-neutral competitive arbitrageurs, and noisy supply of the risky asset, first studied by Vives (Rev Financ Stud 8:3–40, 1995a, J Econ Theory 67:178–204, 1995b) 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.
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We benefited from comments by seminar audiences at Queen’s University, University of Minnesota, Cornell University, HEC Paris, 2007 CARESS-Cowles Conference and 2007 SAET Conference. We are grateful to the editors of this Special Issue for useful suggestions.
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Ozsoylev, H., Werner, J. Liquidity and asset prices in rational expectations equilibrium with ambiguous information. Econ Theory 48, 469–491 (2011). https://doi.org/10.1007/s00199-011-0648-0
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DOI: https://doi.org/10.1007/s00199-011-0648-0