Precise Private Information Research Articles

When large traders create noise

We consider a market where large investors do not only trade on information about asset fundamentals. When they trade more aggressively, the price becomes less informative. Other investors who learn from prices, in turn, are less concerned about adverse selection and provide more liquidity, causing large investors to trade even more aggressively. This trading complementarity can engender three unconventional results: i) increased competition among large investors makes all investors worse off, ii) more precise private information reduces price informativeness, creating complementarities in information acquisition, and iii) multiple equilibria emerge. Our results have implications for competition and transparency policies in financial markets.

More Risk, More Information: How Passive Ownership Can Improve Informational Efficiency

Abstract We identify a novel economic mechanism through which passive ownership positively affects informational efficiency in the cross-section of firms. Passive investors’ inelastic demand lowers a firm’s cost-of-capital, inducing it to take more risk. The higher cash flow variance, in turn, incentivizes active investors to acquire more precise private information, pushing up price informativeness for firms with high passive ownership. High passive ownership also implies higher stock prices and higher stock-return variances. An increase in the aggregate size of passive investors amplifies these cross-sectional differences. We also document complementarities in firms’ real investment and investors’ information choices that can cause information crashes. Received May 31, 2020; editorial decision January 4, 2023 by Editor Holger Mueller. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online

On the Relation between Private Information and Non-Fundamental Volatility

Abstract It is a well-established property that more precise private information leads to lower non-fundamental volatility in a coordination economy with dispersed information. In this note, we identify conditions under which such an argument holds or does not hold. In particular, we show that the opposite relationship holds when (1) there is a strong positive correlation between private information of different agents and (2) public information is endogenously generated.

Word-of-mouth communication, noise-driven volatility, and public disclosure

This paper examines how a firm adjusts its disclosure quality in response to technological innovations that improve investors' private information. We show that more precise private information can endogenously amplify supply shocks and, hence, increase noise-driven (or non-fundamental) price volatility. We study how the firm reacts to such changes and derive a necessary and sufficient condition under which the firm improves its disclosure quality when investors are informed with better private signals. We then apply our model to study investors' private word-of-mouth communication. Our analysis highlights a “dark side” of word-of-mouth communication and a call for better public disclosure even if private communication is assumed to be unbiased and truthful. We provide empirical predictions regarding how price volatility, market depth, and firms’ disclosure qualities would change as technological innovations, such as social media, facilitate information sharing among investors.

Aggregate and Bank-specific Information Disclosure in Bank Stress Tests

This paper studies how a bank regulator’s aggregate and bank-specific information dis-closure policy affects social welfare. We apply global games to studying an economy where depositors, with strategic complementarities among them, face uncertainties about both aggregate and bank-specific information of a bank. Then we examine how disclosure policy of a bank regulator on the bank’s aggregate and bank-specific information affects welfare. With the assumption that bank depositors rely on the bank regulator to collect aggregate bank performance information but have precise private information about bank-specific in-formation, we find that more precise aggregate information disclosed by the bank regulator improves welfare when bank fundamentals are either extremely strong or weak, but tends to reduce welfare when the fundamentals are in the intermediate range where coordination plays a key role. In contrast, more precise bank-specific information disclosed by the regulator tends to increase welfare, even when the fundamentals are in the intermediate range.

Market Power and Welfare in Asymmetric Divisible Good Auctions

We analyze a divisible good uniform-price auction that features two groups each with a finite number of identical bidders. Equilibrium is unique, and the relative market power of a group increases with the precision of its private information but declines with its transaction costs. In line with empirical evidence, we find that an increase in transaction costs and/or a decrease in the precision of a bidding group's information induces a strategic response from the other group, which thereafter attenuates its response to both private information and prices. A stronger bidding group -which has more precise private information, faces lower transaction costs, and is more oligopsonistic- has more market power and so will behave competitively only if it receives a higher per capita subsidy rate. When the strong group values the asset no less than the weak group, the expected deadweight loss increases with the quantity auctioned and also with the degree of payoff asymmetries. Market power and the deadweight loss may be negatively associated.

Audit Committee Financial Expertise and Information Asymmetry

We examine the association between audit-committee expertise and asymmetric information in the U.S. equity market. Using precise private information extracted from a decomposed bid-ask spread, we find that the existence of an audit committee with financial expertise is negatively associated with information asymmetry. We further find CEO duality to mediate the association between audit-committee financial expertise and information asymmetry. More specifically, we document a significant positive association between the interaction term of CEO duality and audit-committee financial expertise and information asymmetry. Our results are robust to several market-microstructure measures of asymmetric information (e.g., quoted spread, effective spread, price impact, the probability of informed trading), firm-specific characteristics, and market-liquidity measures.

Do banks care about analysts' forecasts when designing loan contracts?

AbstractWe investigate whether banks rely on the information content in equity analysts’ annual earnings forecasts when assessing the risk of potential borrowers. While a long literature finds that analysts provide useful information to market participants, it is not clear that banks, which have access to privileged information, would benefit from publicly available analysts’ forecasts. If, however, banks do rely on this information, then more precise private information in earnings forecasts may inform banks. We focus our analysis on the requirement of collateral because it is a direct measure of default risk, whereas other loan terms such as interest spread and debt covenants can also protect against other risks, such as asset misappropriation. The direct link between collateral and default risk allows us to examine whether information from analysts is relevant to banks when designing loan contracts. Consistent with our predictions, we find that higher precision of the private information in analysts’ earnings forecasts is associated with a lower likelihood of requiring collateral, and this effect is larger when a borrower does not have a prior relationship with the lender or their accounting or credit quality is low. We also find that this association disappears after the implementation of Regulation FD, consistent with this regulation reducing analysts’ access to private information.

Word of Mouth, Noise-Driven Volatility, and Public Disclosure

This paper examines how a firm adjusts its disclosure quality in response to technological innovations that improve investors' private information. We show that more precise private information can endogenously amplify supply shocks and, hence, increase noise-driven (or non-fundamental) price volatility. We study how the firm reacts to such changes and derive a necessary and sufficient condition under which the firm improves its disclosure quality when investors are informed with better private signals. We then apply our model to study investors' private word-of-mouth communication. Our analysis highlights a dark side of word-of-mouth communication and a call for better public disclosure even if private communication is assumed to be unbiased and truthful. We provide empirical predictions regarding how price volatility, market depth, and firms' disclosure qualities would change as technological innovations, such as social media, facilitate information sharing among investors.

Origins of Impersonal Markets in Commercial and Communication Revolutions of Europe

In the sixteenth century some northwest European cities underwent institutional change. These cities removed privileges that members of certain merchant guilds enjoyed, and began to develop contractual infrastructure necessary for the functioning of modern impersonal markets. I find that these modernizing cities became distinct in their consumption of ``bourgeois trade-related content only in the late sixteenth century and had peculiar geographic characteristics. They were at the Atlantic coast, and had an early lead in adoption of printing, influenced by their closeness to Mainz where the movable type printing press was invented. Such geographical features exposed these cities to the simultaneous trade and information shocks of Atlantic trade and the Gutenberg printing press, in the late fifteenth century. These shocks made market opportunities outside of guilds lucrative and provided precise private information about these opportunities triggering market development and the endogenous evolution of supporting economic institutions. By examining the factors that triggered a structural change in northwestern Europe - at a disruptive period in history - the paper contributes to the understanding of how modern markets evolve.

Market Power and Welfare in Asymmetric Divisible Good Auctions

We analyze a divisible good uniform-price auction that features two groups each with a finite number of identical bidders. Equilibrium is unique, and the relative market power of a group increases with the precision of its private information but declines with its transaction costs. In line with empirical evidence, we find that an increase in transaction costs and/or a decrease in the precision of a bidding group.s information induces a strategic response from the other group, which thereafter attenuates its response to both private information and prices. A “stronger” bidding group - which has more precise private information, faces lower transaction costs, and is more oligopsonistic - has more market power and so will behave competitively only if it receives a higher per capita subsidy rate. When the strong group values the asset no less than the weak group, the expected dead-weight loss increases with the quantity auctioned and also with the degree of payoff asymmetries. Market power and the dead-weight loss may be negatively associated.

Learning and coordination with dispersed information

We analyse adaptive learning in a model of incomplete and dispersed information, with externalities and strategic interactions. We build on the framework proposed by Angeletos and Pavan (2007a) and extend it to a dynamic multi-period setting where agents need to learn to coordinate. We derive conditions under which adaptive learning obtains in such setting and show that, when actions are strategic substitutes, the information structure affects the speed of convergence: while more precise private information is beneficial, better public information has negative effects. We also show that adaptive learning dynamics converge to the Bayesian Nash equilibrium, which means that agents can learn to act strategically by relying only on observable (exogenous) information.

Why Forecasters Disagree? A Global Games Approach

We study forecast dispersion for a class of finite-player forecasting games that feature a coordination motive and dispersed information. In doing so, we isolate strategic interactions among forecasters that originate in games with a finite set of players. We first show that the finite-player strategic incentive goes in the opposite direction to the underlying coordination motive. Hence, forecast dispersion can be misrepresented if finite-player strategic interactions are neglected. We then explore the role of dispersed information on forecast dispersion and demonstrate that the effect of more precise private information on increasing dispersion is more likely in finite-player games with substitutability relative to games where the set of players is a continuum. Further, the disclosure of more precise public information does not necessarily reduce forecast dispersion in the presence of the endogenous private information choice, which is more likely in finite-player games with complementarity than in continuum-player counterparts.

Optimal Information Disclosure: Quantity vs. Quality

A sender chooses ex ante how her information will be disclosed to a privately informed receiver who then takes one of two actions. The sender wishes to maximize the probability that the receiver takes the desired action. The sender faces an ex ante quantity-quality tradeoff: sending positive messages more often (in terms of the sender's information) makes it less likely that the receiver will take the desired action (in terms of the receiver's information). Interestingly, the sender's and receiver's welfare is not monotonic in the precision of the receiver's private information: the sender may find it easier to influence a more informed receiver, and the receiver may suffer from having more precise private information. Necessary and sufficient conditions are derived for full and no information revelation to be optimal.

Portfolio choice and private information: A note

How does the arrival of information affect portfolio choice? What is the value of private information? This work examines the impact of private information in a setting where agents make portfolio decisions. We find that more that quantity of private information, what really matters to answer the above questions is how accurate is that information. Indeed, asset allocation decisions differ among informed and uninformed agents only if the quality of information is good enough. Furthermore, we find that agents endowed with a high accurate signal will invest more than uninformed agents, and the larger its precision, the larger the share allocated to the risk asset. The higher the degree of risk aversion, the higher the monetary value of the information, although not in a monotonic way. We also show that more information is beneficial only when it is of greater quality. When the solutions are interior, the value of information is affected by the precision of the signal, as well as the probability of having a good state but it is not influenced by variables like wealth, risk-free rate and the level of payoffs. The more precise private information is, the higher the value of that information; and the larger the initial prior of having a high return, the less useful that information is. We find that when the agents have private information, their portfolio choice becomes more sensitive to the arrival of new information, provided the quality of it is good enough. We also show that more information is beneficial only when it is of greater quality. When the solutions are interior, the value of information is affected by the precision of the signal, as well as the probability of having a good state but it is not influenced by variables like wealth, risk free rate and the level of payoffs. The paper shows that the more precise private information, the higher the value of information. Furthermore, the larger the initial prior of having a high return, the less useful the information.

Market power and reputational concerns in the ratings industry

This paper studies the incentives of rating agencies to reveal the information that they obtain about their client firms. In the model, rating agencies seek to maximize their reputation and protect their market power. They observe public information and obtain either precise or noisy private information about a firm. Reputational concerns dictate that a rating reflects private information when it is precise. However, when private information is noisy, two situations arise. In a monopoly, the rating agency may ignore private information and issue a rating that conforms to public information. Under some conditions, it may even become cautious and issue bad ratings ignoring both types of information. With competition, however, it has incentives to contradict public information as a way to pretend that it holds precise private information. Moreover, it may become more likely to issue good ratings in an attempt to protect market power.

Coordination Failure in Investment, Economic Growth, and Volatility

This paper applies global games to the study of an economy with investment complementarities and heterogeneous private information. I establish a two-sector OLG model in which capital goods can be produced by two technologies. One is a safe technology with a publicly known constant return. The other is a risky technology exhibiting technological externalities with an uncertain return about which economic agents have heterogeneous private information. I find that coordination failure arises, and is most severe when the returns of the safe and risky technologies are close. I also find that more precise private information does not necessarily improve social welfare, while more precise public information can unambiguously improve social welfare. Moreover, risk attitudes of economic agents can affect the economy, inducing a positive relationship between economic growth and volatility. Last, I find that a subsidy on the risky technology investment can greatly alleviate coordination failure and improve social welfare.

Uncommon Value: The Characteristics and Investment Performance of Contrarian Funds

Theories of herding behavior predict that only investors with sufficiently precise private information or those most overconfident will deviate from the crowd. Using portfolio holdings, this paper identifies contrarian funds as those pursuing distinctive investment strategies, i.e., as those most frequently trading against the “herd” (against the majority of funds). We find that contrarian funds tend to experience greater inflows and past performance, indicating that their managers either have lower career concerns or are overconfident when trading against the crowd. Our analysis of both fund holdings and trades reveals that contrarian funds possess superior stock selection information (rather than merely being overconfident), and also frequently benefit from their provision of liquidity to herding funds by trading against them. As a consequence, contrarian funds exhibit significantly higher Carhart (1997) four-factor alphas, net of expenses, even after controlling for various performance-relevant fund characteristics. We further compute a stock-level contrarian score that reflects the aggregate information possessed by contrarian funds. Top-decile contrarian stocks outperform bottom-decile stocks by a characteristic-adjusted return of 0.49% per quarter during the four quarters after portfolio formation. Further investigation shows that the stock selection information captured by the contrarian score is not subsumed by the return-predictive information contained in an extensive list of quantitative stock characteristics derived from past research. Our findings suggest that contrarian managers possess unique fundamental stock information.

Market Power and Reputational Concerns in the Ratings Industry

This paper studies the incentives of rating agencies to reveal the information that they obtain about their client firms. In the model, rating agencies seek to maximize their reputation and protect their market power. They observe public information and obtain either precise or noisy private information about a firm. Reputational concerns dictate that a rating reflects private information when it is precise. However, when private information is noisy, two situations arise. In a monopoly, the rating agency may ignore private information and issue a rating that conforms to public information. Under some conditions, it may even become cautious and issue bad ratings ignoring both types of information. With competition, however, it has incentives to contradict public information as a way to pretend that it holds precise private information. Moreover, it may become more likely to issue good ratings in an attempt to protect market power.

Discussion of “The Role of Information Precision in Determining Cost of Equity Capital”

Botosan, Plumlee, and Xie (this issue) demonstrate an association between a proxy for cost of capital and proxies for public and private information precision. These proxies have limitations that suggest caution in interpreting their results, absent evidence of proxy validity. The proxy for cost of capital is based on Value Line's beliefs about expected returns, not actual expected returns. The proxy for private information measures information revealed by analysts, not information used by inside traders. In this paper, Botosan, Plumlee, and Xie (this issue; hereafter BPX) empirically explore the joint effect that public and private information precision have on the cost of equity capital. Their key findings are that more precise public information lowers the cost of capital, while more precise private information raises the cost of capital. The paper considers whether public and private information are substitutes or complements but finds no evidence of an interactive effect. This is an important question with significant policy implications for firms, investors, and regulators. While there is (as the authors discuss) considerable prior literature on the topic, the matter is empirically unsettled, so further evidence is welcome. Also, the authors make an important point that, given the correlation between public and private information, it is essential to control for one when analyzing the effect of the other. The reliability of the results in BPX depends on whether the proxies used in the paper effectively measure the underlying economic constructs. Cost of equity capital is proxied by a formula using Value Line forecasts, while public and private information measures are based on analyst forecast dispersion and accuracy. Most of the following discussion considers how reliable these proxies might be.