Asset Pricing Under Asymmetric Information About Distribution of Risk Aversion∗

We study a dynamic competitive equilibrium model with asymmetric information about time-variant aggregate risk aversion. We show that there still exists a linear price function in out model, a nice result in the other asymmetric information competitive equilibrium models. Furthermore, we show that in our model, asymmetric information play a role in the long run risk premium. When the proportion of informed agents is large, the risk premium will monotonically decrease as more agents become informed because of less uncertainty. When the proportion of informed agents is small, the adverse selection brought by the asymmetric information will increase the long-run risk premium. Furthermore, an increase in the noise about aggregate risk aversion may decrease risk premium when there is enough asymmetric information. We also show that our model predicts positive correlation between volume and absolute dividend change, volume and absolute price change. Expected future excess returns are negatively related to current volume and current dividend change, current volume and price change, current volume and current excess returns. All these are consistent with empirical facts in the literature. ∗This is a revised chapter of my PhD thesis at Wharton School. I thank Andy Abel for introducing me to this project and several conversations on the topic. I thank Bruce Grundy, Domenico Cuoco, and seminar participants at University of Melbourne for helpful comments. Needless to say, all remaining errors are mine. †Finance Department, Faculty of Economics and Commerce, University of Melbourne, VIC 3010, Australia. Email: [email protected]