Strategic Informed Trades, Diversification, and Expected Returns

• In Event: Financial Reporting, Regulation and Expected Returns

Abstract

We examine how imperfect competition impacts expected returns in the large economy limit of a noisy rational expectation equilibrium. In our model, both an informed and uninformed traders consider the impact of their demands on price. Similar to the case of competitive informed traders, we show that factor loadings (betas) explain all cross-sectional differences in expected returns. Asymmetric information does not create a new, priced risk, but does impact the pricing of systematic risks. In particular, private information creates two forces that have opposite effects on expected returns. Prices partially reveal private information about systematic risks, which reduces factor risk premiums. Imperfectly competitive traders reduce their absorption of systematic risk when they are privately informed, which increases factor risk premiums. In a setting with a monopolist privately informed trader, the latter effect dominates, which contrasts to settings with price-taking informed traders. An implication of the results in the large economy limit is that firm-specific accounting practice is likely to affect firm value only through cash flow (numerator) effects.

Authors

• Judson A Caskey, The University of Texas at Austin

• John S Hughes, University of California, Los Angeles

• Jun Liu, University of California, San Diego