Liquidity and Asset Prices in Rational Expectations Equilibrium with Ambiguous Information

28 Pages Posted: 29 May 2009 Last revised: 25 Apr 2015

See all articles by Han N. Ozsoylev

Han N. Ozsoylev

Ozyegin University

Jan Werner

University of Minnesota - Twin Cities - Department of Economics

Date Written: May 26, 2009

Abstract

The quality of information in financial asset markets is often hard to estimate. This paper analyzes information transmission in asset markets when agents treat information of unknown quality as ambiguous. We consider a market with risk-averse informed investors, risk-neutral competitive arbitrageurs, and noisy supply of the risky asset, first studied in Vives (1995a,b) with unambiguous information. Ambiguous information gives rise to the possibility of illiquid market where arbitrageurs choose not to trade in a rational expectations equilibrium. When market is illiquid, small informational or supply shocks have relatively large effects on asset prices. We show that trading volume decreases and liquidity risk increases with ambiguity about probability distribution of asset payoffs. High ambiguity may lead to excess volatility of asset prices.

Suggested Citation

Ozsoylev, Han N. and Werner, Jan, Liquidity and Asset Prices in Rational Expectations Equilibrium with Ambiguous Information (May 26, 2009). Economic Theory, Vol. 48, No. 2, 2011, Available at SSRN: https://ssrn.com/abstract=1410402 or http://dx.doi.org/10.2139/ssrn.1410402

Han N. Ozsoylev (Contact Author)

Ozyegin University ( email )

Kusbakisi Cd. No: 2
Altunizade, Uskudar
Istanbul, 34662
Turkey

Jan Werner

University of Minnesota - Twin Cities - Department of Economics ( email )

271 19th Avenue South
Minneapolis, MN 55455
United States

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