Price Volatility and Investor Behavior in an Overlapping Generations Model with Information Asymmetry



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    • Masahiro Watanabe is at the Jones Graduate School of Management, Rice University. This paper is based on Chapter 2 of my dissertation at Yale University and was previously circulated under the title “Rational Trend-followers and Contrarians in Excessively Volatile, Correlated Markets.” A technical appendix is available on the author's home page, I am grateful to my adviser, Matthew Spiegel, for helpful comments and encouragement. The guidance of Robert Stambaugh (the editor) and an anonymous referee substantially improved the paper. I also thank Arturo Bris, Zhiwu Chen, William Goetzmann, Roger Ibbotson, Jonathan Ingersoll, Andrew Jeffrey, Hayne Leland (Blaise Pascal Conference discussant), Harry Mamaysky, Barbara Ostdiek, Lasse Pedersen, Jiang Wang (AFA discussant), Akiko Watanabe, participants at the 2003 AFA and the 2002 APFA/PACAP/FMA meetings, participants at the Blaise Pascal International Conference on Financial Modeling, and seminar participants at Boston College, Georgia Tech, Notre Dame, New York University, Rice, UC Irvine, Washington-Seattle, Washington-St. Louis, Wisconsin-Madison, and Yale School of Management. All remaining errors are mine.


This paper studies an overlapping generations model with multiple securities and heterogeneously informed agents. The model produces multiple equilibria, including highly volatile equilibria that can exhibit strong or weak correlations between asset returns—even when asset supplies and future dividends are uncorrelated across assets. Less informed agents rationally behave like trend-followers, while better informed agents follow contrarian strategies. Trading volume has a hump-shaped relation with information precision and is positively correlated with absolute price changes. Finally, accurate information increases the volatility and correlation of stock returns in the highly volatile, strongly correlated equilibrium.