Essays on information asymmetry in financial market

I study how asymmetric information affects the financial market in three papers. In the first paper, I study the joint determination of optimal contracts and equilibrium asset prices in an economy with multiple principal-agent pairs. Principals design optimal contracts that provide incentives for agents to acquire costly information. With agency problems, the agents’ compensation depends on the accuracy of their forecasts for asset prices and payoffs. Complementarities in information acquisition delegation arise as follows. As more principals hire agents to acquire information, asset prices become less noisy. Consequently, agents are more willing to acquire information because they can forecast asset prices more accurately, thus mitigating agency problems and encouraging other principals to hire agents. This mechanism can explain many interesting phenomena in markets, including multiple equilibria, herding, home bias and idiosyncratic volatility comovement. In the second paper (co-authored with Yao Zeng from Harvard University), we investigate how firms’ cross learning amplifies industry-wide investment waves. Firms’ investment opportunities have idiosyncratic shocks as well as a common shock, and firms’ asset prices aggregate speculators’ private information about these two shocks. In investing, each firm learns from other firms’ prices to make better inference about the common shock. Thus, a spiral between firms’ higher investment sensitivity to the common shock and speculators’ higher weighting on the common shock emerges. This leads to systematic risks in investment waves: higher investment and price comovements as well as their higher comovements with the common shock. Moreover, each firm’s cross learning creates a new pecuniary externalities on other firms, because it makes other firms’ prices less informative on their idiosyncratic shocks through speculators’ endogenous over-weighting on the common shock. In the third model, we study the effect of introducing an options market on investors’ incentive to collect private information in a rational expectation equilibrium model. We show that an options market has two effects on information acquisition: a negative effect, as options act as substitutes for information, and a positive effect, as informed investors have less need for options and can earn profits from selling them. When the population of informed investors is high because of the low information acquisition cost, the supply for options is larger than the demand, leading to low option prices. Low option prices in turn induce investors to use options instead of information to reduce risk, while informed investors have little opportunity to earn profits from selling options to cover their information acquisition cost. Introducing an options market thus decreases investors’ incentive to acquire information, and the prices of the underlying assets become less informative, leading to lower prices and higher volatilities. A dynamic extension of this analysis shows that introducing an options market increases the price reactions to earnings announcements. However, when the information acquisition cost is high, the opposite effects arise. Further analysis shows that our results are robust for more general derivatives. These results provide a potentially unified theory to reconcile the conflicting empirical findings on the options listing of individual stocks in both the U.S. market and international markets.