Equilibrium in Economy Where Trades Have Dierential Information

August 2005

This paper describes alternative models for a speculative market economy in which investors have dierential information regarding returns of risky assets. It explains the crucial role played by equilibrium prices to aggregate and transmit information, and how such markets might become overinformationally ecient. The paper goes on to describe a more complex and realistic model of a multi-asset economy, and a model where information is costly to acquire.

Introduction

Information relating to prices and expected payos helps investors accurately value the nancial assets being traded in the market based, on which they decide whether to buy, sell or hold on to their investments. But information is not homogeneous among investors. The implication and importance of diversity in information among investors is clearly demonstrated by the extreme case of insider trading. Insiders have access to special information which others dont, and hence have an unfair advantage. Fund managers also claim to outperform others based on their superior information. It is now well known that in a speculative economy where traders have diverse information, the equilibrium price acts as an aggregator and transmitter of information. In the next section we will see how our model conrms this result, but to get some intuition and see how the models incorporate this idea, consider an economy which repeats itself. Then, over many cycles of trading, investors will learn the joint distribution of the price of the asset and the information of individual investors. In the future when the investors observe the market price of an asset, they will back-out and extrapolate the aggregate information held by all investors in the market. When investors learn from prices as demonstrated above, they are said to have rational expectations and any equilibrium where agents behavior is inuenced by the market price of assets along with their own beliefs is then a Rational Expectations Equilibrium.

Fully Revealing Rational Expectations Equilibrium, equilibrium where prices symmetrisize information by revealing all the information of the informed to the uninformed, runs into conceptual diculties. When prices reveal all the information in the market, individuals realize that information obtained from these prices is superior to their own. This makes their personal information redundant and removes any economic incentive to collect costly information. If all investors think similarly, there is no justication for any individual to collect information. If nobody is informed, it is protable to be informed. Hence fully revealing Rational Expectations Equilibrium is not stable. The only way equilibrium will be stable is when there is noise in the equilibrium price system so that prices cannot reveal all the information of the informed to the uninformed. In such a Noisy Rational Expectations Equilibrium, the investors benet from information collected by others, which they estimate from prices, but do not nd their personal information redundant. There is no tension in the optimal use of price and the equilibrium can be maintained in the market. The following section describes various models which make our arguments formal and rigorous. We start with a simple model with only one risky asset and demonstrates how fully revealing rational expectation equilibrium is not a stable equilibrium. The main problem with such a model, the absence of any randomness to prevent prices from being fully revealing, is dealt in subsequent models by treating aggregate supply of assets as random. Finally we consider more complex models dealing with multi-asset economy and costly information. For the multi-asset model, it is shown by means of an example, that results from single-asset models dont carry into the multi-asset setting. The paper ends with a list of further readings and a few potential research directions.

The Model

We start by considering a two period economy with T traders and two assets, one risky and one riskless. Traders invest in the rst period and consume in the second period. Each investor is assumed small so that the trading activities of any individual does not inuence the equilibrium prices in the economy. The unit cost of the risky asset is P at time 0 and the time 1 payo is a random variable denoted by F . The riskless asset is treated as the numeraire and its time 0 and time 1 price is normalized to 1. Before trading begins, each investor receives a piece of private information about the time 1 payo of the asset. Noise in his information prevents exact knowledge of the payo. The precision of the signal received by all the investors is assumed identical. The signal is given by

 Yi = F + i , i = 1...T,

(1)

2 where F is N(0,f ) and i , i = 1, ..., T are i.i.d with distribution N(0, 2 ). F and the i are independent of each other. W0i is the endowment of investor i, whose utility has an exponential form given as Ui (x) = eai x , where ai is the coecient for risk aversion for trader i. Therefore investors have constant absolute risk aversion and their demands are independent of initial endowment. If i is the demand for shares of the risky asset, the time 1 wealth of investor i is W1i = i (F P ) + W0i .

Each investor maximizes expected utility of wealth conditional on the signal received i.e. individual solves max
i E[U (W1i )

| Yi = yi ].

(2)

The conditional distribution of W1i given Yi is normal. This gives us the demand for investor i for the risky asset, i = E[F | Yi ] P . ai var(F | Yi ) (3)

The assumption that densities are normal allows for closed-form solutions and ensures that joint and conditional distributions are normal and the demand function is linear in Yi and P . From the market clearing condition,
T T

Z=
i=1

i =
i=1

E[F | Yi , P ] P , ai var(F | Yi , P )

(4)

where Z is the total supply of the risky asset. Grossman (1976) nds a close form solution for the price function for the model developed above. The price conjecture used is P = 0 + 1 Y , where Y = Solving the model gives, 0 =
2 f Z 2 ( 2 + T f ) T 1 i=1 ai T i=1 Yi

(5)

1 =

2 T f 2 ( 2 + T f )

The initial endowments do not enter the expression, a consequence of using the exponential utility function. On closer inspection, 1 > 0 in the above equations would enable any trader to calculate Y by observing P . This means that price is aggregating investor information and transmitting it to everyone. Grossman (1976) shows estimate of F made by using both Y and Yi is independent of Yi i.e. is a sucient statistic for Yi . Hence after observing P the investor nds Y that the information obtained from prices is of better quality and his own information is redundant. This eliminates any motivation for individuals to collect costly information. But when nobody collects any information, there is nothing for prices to aggregate. Therefore the equilibrium is not stable and breaks down. To overcome the limitation of the above model, Grossman (1976) and Grossman and Stiglitz (1980) suggest that there is an equilibrium degree of disequilibrium in the market. They argue that there has to be noise in the equilibrium prices so that they do not reveal all the information. In their paper noise is introduced by taking the aggregate supply of assets as random. The equilibrium price is now aected by both, changes in supply of the asset or changes in the quality of information, but investors cannot distinguish between the two and hence price is not fully revealing. There is then reward from investing in information and the equilibrium thus obtained does not suer from the earlier shortcoming of individuals lacking motivation to collect information. To develop such a model, let the endowment of investor i be vi which 2 is N(0, v ) and independent of F and the i , i = 1...T . The total supply of asset in the market is now random denoted by
T

Z=
i=1

vi .

2 Z is then N(0, T v ). The investors are still expected utility maximizers but the only information they have about the supply of risky asset in the market comes from their endowment of the asset. The form of the price function is taken as P = 0 + 1 Y 2 Z, 2 = 0. (6)

The reason 2 has to be non-zero is to prevent equilibrium prices from being fully revealing. The closed form solution has been found in [5], Huang and Litzenberger. From the price function above, it is clear that price is aected by both Y and Z. It is not possible to isolate the eect of either of the two individually and correspondingly price does not reveal all the information. A similar but generalized model has been developed by Diamond 4

and Verracchia (1980). They consider the equilibrium price as a function of investor information only through their individual demands. A natural extension is to consider more assets and Admati (1985) uses similar framework to extend the model to multiple assets and a continuum of investors. In the paper she is able to nd closed-form expressions for prices and, more interestingly, develop number of examples to show the existance of counter-intuitive results in the multi-asset environment. These results cannot be obtained from a generalization of the two asset models. An example demonstrating how such results can be obtained is delineated later but the driving force behind such results is the correlation among the payos and among the supply of dierent assets i.e. the structure of the variance-covariance matrices. For the model with N risky and one riskless asset with T traders, the expression for time 1 wealth is given by W1i = i (F P ) + W0i , and the price function is taken as
T

P = 0 +
i=1

1i Yi 2 Z.

The notation now represent matrices rather than scalars. Lastly, the signals of individuals are allowed to be asymmetric by having dierent variances. Admati develops her model in the case of innite investors. These continuum of investors are indexed by a [0, 1] and the economy is dened 1 as a function (, S 1 ) : [0, 1] + X nXn , where (a , Sa ) is the value of the function at a. Each agent observes the signal Ya = F + where a ( a )a[0,1] are i.i.d normal with mean vector zero and covariance Sa . The price function used by Admati in the continuum of agent case is P = 0 + 1 X 2 Z. (7)

Here price is a function of the actual future payo of the asset and not the aggregate information becuase the collective information of all innite agents in the economy averages out the error terms and the market as a whole has perfect information about the cash ows. 1 The paper describes
1 If (a )a[0,1] is a stochastic process, then the Lebegue integral 0 a da might or might not be well dened because of measurability constraint on the realization of our process (as a function of a). But if E(a ) = 0, a and Var(a ) are uniformly bounded, then for every sequence {an } of distinct indices from [0,1], the strong law of large numbers applied N to the sequence (an ) yields that (1/N ) n=1 an 0 almost surely. Admati thus claims 1 it is reasonable to dene a da = 0. She rst assumes the integral she is dening is linear 1 1 1 1 and writes it as 0 a da = 0 (a E(a ))da + 0 E(a )da. The rst term on the right goes to zero by the argument above and hence the result follows. She continues with the 0

how a closed form solution for the model is obtained and what are the factors aecting the constants in the price function. The counter-intuitive results obtained for a multi-asset can be best seen using a simple example taken from the paper. Consider two risky assets a and b with the covariance matrix for F and respectively being Z vaa vab V = vba vbb U= uaa uab uba ubb

Let vbb >> vaa > 0 and uaa > ubb > 0 for our example. Consider an increase in the price of asset a, Pa with the price of asset b, Pb held constant. A rational investor will take this as a signal of higher future payo for asset a, Fa . The high degree of positive correlation between the payos of the two assets would then suggest that the payo of asset b, Fb , would also increase, and by a greater amount. The only way Pb is expected to remain constant is if its supply, Zb , increases. The positive correlation between the supply of the assets would again mean that supply of a, Za , also increases, and by more than Zb . This will tend to decrease Pa beyond the initial increase. So an increase in Fa resulting from an increase in Pa with Pb held constant produces inconsistent result. A decrease in Fa is more consistent: When Fa decreases, Fb also reduces and to keep prices constant, there is an drop in Zb . a , which raises Pa and reinforces the This is accompanied by decrease in Z initial increase. Hence we see that increase in the price of the asset might lead to decrease in future payo. This is one example which goes against the intuition developed in earlier models and shows how the variance-covariance stucture can produce suprising results when multiple assets are considered. Another impressive feature of a multi-asset economy which comes out of the Admati paper is that the supply of each asset in the economy does not have to be unknown for the equilibrium to be stable. Noise in the supply in any asset aects the prices of remaining assets (the exact degree depends on the correlation structure) and prevents the prices of assets with known supplies from becoming fully revealing. Secondly, even if the payo of an asset is known perfectly, the investor can obtain information about other assets through signal relating to this rst asset. This is again due to the correlation between dierent assets in the economy. So the conditions for the equilibrium to exist in this setting are not as strict as those in the earlier models.
argument that if (a )a[0,1] are as above and ( )a[0,1] is almost surely integrable, then a 1 )da = 1 da. Now if we return to our model, the error terms { }a[0,1] is (a + a a 0 0 a 1 1 similar as the ( )a[0,1] above and so we can write 0 Ya da = 0 (X + )da = X almost a a surely.

An alternative direction of reseach relates to models where investors have to pay to acquire information. In such models, they have to make the decision to buy the information or not, depending on how that eects their expected utility. Grossman and Stiglitz (1980) explore this in a Two-Asset Two-Period setting. The model is constructed as follows. There is one piece of information and all investors who decide to buy get the same information. The payo F of the risky asset is random and given by F = + . Investors can know the value of at a price k. The informed and the uninformed investors are identical apriori and the classication just depends on whether they purchase information or not. When traders buy information, they obtain knowledge of the payo accurately to a precision of , and their demand for the risky asset then depends on and P , the price in the market. Demand of uninformed individuals just depends on P . The supply of the asset is random denoted by Z. If denotes the percentage of investors who decide to become informed, then the price function is of the form P (z, ). The uninformed dont know the value of z and hence cannot extrapolate from price. The amount of information the investors can extract from the equilibrium price depends on how noisy the price is. The investors weigh this against the benet if they buy the information. At the margin, the expected benet from buying information is zero. Thus the equilibrium can be obtained by equating the expected utility of the informed and the uninformed. As long as these two are dierent, investors will nd it protable to switch sides. Grossman and Stiglitz come up with a number of general conjectures which should be true for a general model of this form. Some of them are discussed below. As the number of informed investors increase, the price system becomes more informative. This reduces the utility of being informed and the ratio of utility of informed to the uninformed decreases. This drives the ratio of utilities to one and the market towards equilibrium. A rise in the price of information reduces the expected benet of the information and consequently the fraction of investors who decide to become informed in equilibrium is a decreasing function of the price of information. Increase in the quality of information without any increase in its price produces ambigious results. On one side, this will encourage investors to buy information, since it is more informative. But better quality information will mean that investors who buy information are making more informed decisions, and so the price system is more revealing. This increases the expected benet for the uninformed, discouraging them from buying information. 7

 The noise in the system in the form stochastic supply of assets is the reason prices are not fully revealing. It is clear that more the noise in the system, less informative is the price. Grossman and Stiglitz are not able to verify the conjectures for a general model, but they are able to prove their arguments for a special case where investors have constant risk aversion and all variables are normally distributed. Their closed form solution shows how the ratio of utilities change with the fraction of informed investors. They analyze the case where prices reveal all information as limiting cases of their model by letting the variance of noise go to zero. The results show that as the variance of noise goes to zero, the proportion of informed traders also go to zero. Hence we have fully revealing prices and the equilibrium breaks down. In the nal section of their paper, Grossman and Stiglitz argue why prices cannot be fully revealing. They start by pointing out that dierences in preference is not the only reason driving trade, and dierences in endowment and belief are also important reasons why people trade. Disregarding dierences in preferences, if all traders have identical endowments and beliefs then a competitive equilibrium would leave them with exactly the same share as their endowments, and nobody would trade if there is some cost involved. Grossman and Stiglitz then go on to show there there is continuity in net trade with respect to dierences in beliefs. Based on this argument, as the noise in prices go to zero, traders become identically informed having identical beliefs, and trading thins down to zero. If operating the market is costly it will close down before the equilibrium ceases to exist.

Future Reading and Research

Some areas for further reading and consideration for research are highlighted below. 1. Noise, in the form of stochastic supply of assets, prevent prices from being fully revealing and makes the above models stable. Diamond and Verracchia (1980) write that introducing noise in such a manner may appear somewhat articial. They propose other plausible sources of noise such as individually stochastic life cycle motives for trade, individually stochastic taxes and wonder whether these alternative sources might give more insight into the nature and role of noise in the rational expectations equilibrium. I argue that treating supply of assets as random in the models is not unreasonable and should be interprated as a mixture of stochastic life cycle of individuals trade, which Diamond and Verracchia suggest, and Limited Participation in trading. For the former I reason that most investors have some xed random time they would like stick 8

with their investment before they engage in buying or selling the asset in question again. During this time, their supply is absent from the market when the price is being determined. The Limited Participation I mention is meant to capture the idea that Not all investors are watching prices of all the assets all the time. This might be specially true for assets which are not traded often or assets which make a very small percentage of portfolios. This makes it impossible to give an accurate gure for the total supply of the asset. 2. All the above models are for a competitive equilibrium where individual investors are price takers. Kyles (1989) work addresses the case where the market is imperfect and individual traders can manipulate prices. A Bayesian-Nash Equilibrium framework is used to explore the implications and develop the model. The justication for exploring such a market is that the best informed traders are usually the very large traders who have the capacity of moving the market. 3. Except for the last model, investors are costlessly endowed with information. Treating information gathering as costly would enhance our understanding of the market equilibrium. A more complicated model can be constructed by assuming investors have a choice to buy private heterogeneous information corresponding to payos of risky assets. There could be multiple sources of information with non-uniform cost. The resulting model could be much closer to reality but tractability of such a model is a serious concern. The other aspect to consider is how much would it really add to our understanding of the equilibrium process. We can start by looking at Grossman and Stiglitz (1980) and analyze what happens if we increase from one to two, at non-uniform cost, the pieces of information investors can buy. Do we just get a more complicated model, with no enhancement of our understanding, or do we see some interesting results? What if these pieces of information are not independent? There is scope in this direction and reasonable assumptions might provide mathematical tractability. 4. A prominent work for future reference is by Campbell and Kyle(1993). 5. An idea suggested by Prof David Brown was to use the Multi-Asset Admati model but have teh cash ows take on a factor structure. Unfortunately, the analysis became intractable because the simple structure exploited by Admati for her paper vanished. A dierent approach will have to be used if a solution is to be obtained. Hughes, Liu and Liu (2005) have tried to accomplish a similar goal in their paper and it should be interesting going through their analysis.

References
1. Grossman, S.J., 1976, On the Eciency of Competitive Stock Markets Where Trades Have Diverse Information. Journal of Finance, Vol 31, No 2, 573-585. 2. Diamond, D.W. and Verracchia R.E., 1980, Information Aggregation in a Noisy Rational Expectations Economy, Journal of Financial Economics 9, 221-235. 3. Admati, A.R., 1985, A Noisy Rational Expectations Equilibrium for Multi-Asset Securities Markets, Econometrica, Vol. 53, No. 3, 629-658. 4. Grossman, S.J. and Stiglitz, J.E., 1980, On the impossibility of Informationally Ecient Markets, American Economic Review 70, 393408. 5. Lintner, J., 1969, The Aggregation of Investors Diverse Judgments and Preferences in Purely Competitive Security Markets, Journal of Financial and Quantitative Analysis 4, 347-400. 6. Huang,C. and Litzenberger,R.H., Foundations for Financial Economics, 259-283. 7. Campbell, J.Y. and Kyle, A.S., 1993, Smart Money, Noise Trading and Stock Price Behavior, Review of Economic Studies, 60, 1-34. 8. Kyle, A.S., 1989, Informed Speculation with Imperfect Competition, The Review of Economic Studies, Vol. 56, No.3, 317-355. 9. Hellwig, M.F., 1980, On the aggregation of information in competitive markets, Journal of Economic Theory, Vol 22, 477-498.

10. Hughes, J., Liu, J. and Liu, J.,2005, Information, Diversication and Asset Pricing, Unpublished.

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