The Effects of Public Information with Asymmetrically Informed Short‐Horizon Investors

• Date: 01 June 2014
• Author: YUN ZHANG,QI CHEN,ZEQIONG HUANG
• DOI: http://doi.org/10.1111/1475-679X.12052
• Published date: 01 June 2014

DOI: 10.1111/1475-679X.12052

Journal of Accounting Research

Vol. 52 No. 3 June 2014

Printed in U.S.A.

The Effects of Public Information

with Asymmetrically Informed

Short-Horizon Investors

QI CHEN,

∗ZEQIONG HUANG,

∗AND YUN ZHANG

†

Received 20 June 2012; accepted 23 February 2014

ABSTRACT

This paper analyzes the effects of public information in a perfect competi-

tion trading model populated by asymmetrically informed short-horizon in-

vestors with different levels of private information precision. We first show

that information asymmetry reduces the amount of private information re-

vealed by price in equilibrium (i.e., price informativeness) and can lead to

multiple linear equilibria. We then demonstrate that the presence of both in-

formation asymmetry and short horizons provides a channel through which

public information influences price informativeness and equilibrium unique-

ness. We identify conditions under which public information increases or de-

creases price informativeness, and when multiple equilibria may arise. Our

analysis shows that public information not only directly endows prices with

∗Fuqua School of Business at Duke University; †George Washington University School of

Business.

Accepted by Haresh Sapra. We appreciate the constructive comments from an anonymous

referee. We benefit from discussions with Hengjie Ai, Jeremy Bertomeu, Alexander Bleck,

Philip Bond, Doug Diamond, Pingyang Gao, Raffi Indjejikian, Brian Mittendorf, Katherine

Schipper, Vish Viswanathan, and Jiang Wang. We thank workshop participants at Carnegie

Mellon University, Duke University, Ohio State University, Purdue University, Shanghai Ad-

vanced Institute of Finance, Shanghai University of Finance and Economics, Stanford Uni-

versity, the Washington Area Accounting Conference, University of Chicago, University of

Michigan, University of Minnesota, University of Pennsylvania Wharton School, and Xiamen

University. The authors acknowledge the financial support from their respective institutions.

Chen also acknowledges the support from TsinghuaUniversity, where part of the research was

conducted during his visit there.

635

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

636 Q.CHEN,Z.HUANG,AND Y.ZHANG

more (public) information, it can also have an important indirect effect on

the degree to which prices reveal private information.

1. Introduction

That prices can aggregate and reveal diverse private information held by

individual traders is a cornerstone for well functioning financial markets

(Hayek [1945]). Aggregation occurs via the trading process when investors

condition their trades on the information available to them (Grossman

and Stiglitz [1980], Glosten and Milgrom [1985], Kyle [1985]). Given the

amount of private information traders hold, the trading process serves an

information transmission and production role by enabling prices to reveal

traders’ private information that is otherwise not available to the general

public. In so doing, it enhances the stock price’s role as a public signal

to guide resource allocation decisions. Price informativeness, which refers

to the amount of private information revealed by price in equilibrium, re-

flects the efficiency of this transmission process. Prior studies suggest that

price informativeness can have a significant impact on the real economy.1

For example, it can affect firms’ investment decisions (Luo [2005], Chen,

Goldstein, and Jiang [2007]), cross-listing decisions (Foucault and Fresard

[2012]), and governance choices (Ferreira, Ferreira, and Raposo [2011]).

That prices contain valuable private information also underlies proposals

for policy makers and regulators to base their actions on prices (Bond,

Goldstein, and Prescott [2010]).

In this study, we examine how public information affects price infor-

mativeness in a two-period overlapping trading model with perfect com-

petition, where individual traders have short investment horizons and are

endowed with heterogeneous private information with different precision

levels. To the extent that price informativeness affects the real economy,

understanding whether and how public information affects price informa-

tiveness can shed light on alternative mechanisms through which public

information affects the real economy.

The idea that public information can affect price informativeness is im-

plicit in the conventional wisdom that public information can alleviate the

adverse impact of information asymmetry among investors.2However, prior

1See, for example, Holmstrom and Tirole [1993], Dow and Gorton [1997], Subrahmanyan

and Titman [1999], Goldstein and Gumbel [2008], and Dow, Goldstein, and Gumbel [2011]

for theoretical models. Bond, Edman, and Goldstein [2012] provide an excellent literature

review.

2The effect of information asymmetry on price informativeness is also at the center of the

debate over insider trading. Proponents for insider trading argue that it allows prices to be

more informative, whereas opponents argue that it reduces price informativeness by reduc-

ing market liquidity. See Easterbrook and Fischel [1991]. We focus on how public informa-

tion reduces the adverse impact of information asymmetry on price informativeness. Models

of perfect competition (such as the one we study) assume that traders are price takers and,

therefore, liquidity is not a concern.

THE EFFECTS OF PUBLIC INFORMATION 637

theoretical studies find that, in stock markets with perfect competition,

price informativeness depends only on the average precision of investors’

private information; it does not depend on either information asymmetry

or public information (Verrecchia [1982], Lambert, Leuz, and Verrecchia

[2012]). A key assumption behind these findings is that investors’ invest-

ment horizons are the same as the operating horizons of the firms that

they own.3That is, investors hold stocks until the firms’ final liquidation

dates. This assumption can be restrictive to the extent that investors trade

for various reasons and often close their positions before the final liquida-

tion dates, either because they are subject to exogenous liquidity shocks, or

because they are simply outlived by the firms they invest in.

In this paper, we relax this assumption and study the impact of public

information in a two-period version of Allen, Morris, and Shin [2006] that

allows information asymmetry among investors.4We first establish a mech-

anism through which information asymmetry affects price informativeness.

We then show how this mechanism enables public information to influence

price informativeness.

Our first finding is that information asymmetry among short-horizon in-

vestors unambiguously lowers price informativeness by exacerbating the in-

formation loss caused by short investment horizons. Unlike long-horizon

investors, short-horizon investors face the uncertainty of the next period

price, as opposed to the uncertainty of the fundamentals. Their trades

are thus less sensitive to their private information about the fundamentals,

which reduces price informativeness. Information asymmetry exacerbates

this information loss because the sensitivity of investors’ trades to their pri-

vate information is not uniformly reduced when investors have different

levels of private information precision. Whereas investors with less precise

private information do not reduce their sensitivities as much (because their

sensitivities are not high to begin with), the reduction is more pronounced

among investors with more precise private information. Because price in-

formativeness depends on the average of individual sensitivities, it follows

from the Jensen’s Inequality that the average of individual sensitivities is

lower than the sensitivity of the average investor. This leads to an aggrega-

tion loss in price informativeness caused by information asymmetry, above

and beyond the loss induced by short horizons.

Our second finding is that information asymmetry can give rise to

multiple linear equilibria in situations where the equilibrium is other-

wise unique. We show that short horizons can generate an “endogenous

uncertainty effect” in that the sensitivities of short-horizon investors’ trades

3Another key assumption is perfect competition. It is well known that information asymme-

try matters in models with imperfect competition (e.g., Kyle [1989], Diamond and Verrecchia

[1991], Lambert and Verrecchia [2012]).

4Similar models have been studied in Grundy and McNichols [1989] and Brown and Jen-

nings [1989], and recently in Gao [2008]. None of these papers allow investors to have differ-

ential precisions in their private information.