Information Markets and the Comovement of Asset Prices

Asset prices display high covariance relative to the covariance of their payoffs. (Pindyck and Rotemberg, 1993; Barberis, Shleifer and Wurgler, 2002) Many take this ‘excess covariance’ to be evidence of investor irrationality. This model reconciles the high covariance with a rational expectations framework by introducing endogenous information acquisition. Investors can purchase information about asset payoffs from a competitive, profit-maximizing seller. A rational investor holding a portfolio of assets will not pay for information about every asset. Instead, he will buy information about a subset of the assets and use this information to make inferences about the value of all his assets. Because information production has high fixed costs, competitive producers charge more for low-demand information than for high-demand information. A price that declines in quantity makes investors want to coordinate their purchases of information to reduce its cost. If investors price many assets using a small number of common signals, then shocks to one signal will be passed on as common shocks to many asset prices. These shocks to asset prices, through common signals, generate 'excess covariance.' The cross-sectional and time-series properties of asset price covariance are consistent with this explanation.