The Role of Information in the Discrepancy Between Average Prices and Expectations

Abstract

Abstract In this paper I show how the existence of short-term trading causes a divergence between the average price and the average expectation of the fundamental value by embedding higher-order expectations –expectations of expectations of expectations...– into prices. Short-term trading arises when investors receive private information and (i) either net supply mean reverts or (ii) the release of additional information related to existing information is combined with residual uncertainty. Mean-reversion of net supply, brings the average expectation closer to the fundamental value than the average price after the release of private information. By the contrary, residual uncertainty and an incoming release of information brings the average price closer to the fundamental value than the average expectation before the new information is released. When both (i) and (ii) are present, the average expectation tends to be closer to the fundamental value than the average price in the periods immediately after information releases, but the opposite happens in the periods immediately before information releases.