Price Informativeness and Price Volatility

Abstract We study the equilibrium relation between price volatility and price informativeness in financial markets. We characterize the fundamental relation between these variables within the class of models with linear asset demands and additive shocks. We establish that the relation between both variables is uniquely characterized by the ratio of the signal-to-price demand sensitivities and the variance of the fundamental. We identify two channels through which price informativeness is related to price volatility. The first channel is the noise reduction channel: holding equilibrium behavior constant, an increase in price informativeness reduces price volatility, since less noise is incorporated into the price. The second channel is the equilibrium response channel. An increase in price informativeness increases the signal-to-price demand sensitivities, since investors put more weight on the price as a signal about the fundamental, which increases price volatility. The overall relation between price volatility and price informativeness is nonlinear and can be non-monotonic.