Price-Signal Relations in an Imperfectly Competitive Financial Market with Public and Private Information

Abstract

This paper examines the robustness of Lundholm's [1988] results related to the relation between signals and prices in an imperfectly competitive financial market. In particular, I am interested in finding under which conditions good news translates into higher prices in this new setup. In many rational expectations models with one risky asset (see, for instance, Hellwig [1980] and Diamond and Verrechia [1981]), it holds that the equilibrium price of the risky security increases in the signals observed by investors. In contrast, Lundholm [1988] proposes a context in which the previous intuitive result may fail. More precisely, he extends the rational expectations competitive model of Diamond and Verrecchia [1981] by assuming that each investor receives both a public and a private signal. He shows that when public and private signals' errors are