Information Asymmetry, Price Informativeness and Cost of Capital

Abstract

This paper examines the relationship between two important financial variables (price informativeness, and cost of capital) and information asymmetry, controlling for the total amount of information in the market. In the model, each investor has a private signal. We measure information asymmetry by the dispersion of the precision of the private signals. By doing so, we can isolate the effect of the total amount of information and focus on the influence of information asymmetry. We show that without the non-learnable component in the asset payoff (residual uncertainty) or transaction cost, information asymmetry will not affect the cost of capital and price informativeness, which is consistent with Lambert and Verrecchia (2015). In contrast, with residual uncertainty or transaction cost, an increase in information asymmetry will decrease price informativeness and increase the cost of capital, even in a fully competitive market. Our results highlight the importance for regulators of alleviating information asymmetry to improve market efficiency.