Financial Decision Making with Endogenous Information Acquisition

The project aims to understand the process of endogenous information acquisition in financial markets. Information choices are at the front of any decision making so understanding this process is of great importance to society overall. The project explores various settings of the problem from both theory and empirical perspectives. In a standard decision framework, economic agents update their beliefs based on information (signals) they acquire. While this framework is elegant and provides a solid foundation for our economic thinking, testing it directly poses a formidable task. A major problem is that information choices are not observable and, therefore, most information-based models in finance take information as an exogenous “black box”. Another problem is that information choice models with many assets and heterogeneously informed agents are generally difficult to solve and test. A few sparse contributions in financial economics either assume a simple information structure with two types of agents, informed and uninformed, (Van Nieuwerburgh and Veldkamp, 2009, 2010; Kacperczyk, van Nieuwerburgh, and Veldkamp, 2015) or they solve problems with one risky and riskless asset (Peress, 2004).

My ERC CoG project aims to endogenize information choices in rich economic structures. The individual components identify new ways to model information choices with heterogeneously informed agents and heterogeneous assets in a general equilibrium framework. They show how to match predictions of such models with the data not only qualitatively but also quantitatively. Further, they illustrate ways in which the market structure affects information choices. Finally, they provide empirical micro-foundations for information acquisition and processing in financial markets.

Providing micro-foundations for information and its endogenous acquisition is of first-order importance. From the perspective of academic research, the goal is to understand causal mechanisms that drive economic decisions. The framework in which information is not micro-founded makes it difficult to distill such causality. Establishing causal links in economic data is further important for policy design and its effectiveness. It makes it also possible to take existing modeling paradigms to address questions beyond the narrow modeling framework. The projects in the proposal are among the first to take the literature in this direction both theoretically and empirically. They also study more realistic contexts in which we observe rich heterogeneity both in terms of agents’ information and assets in which they can invest.

Upon the conclusion of the grant period, the project has managed to deliver a number of significant results. The starting part is new theory of information anchored in the heterogeneous world with multiple assets. The follow-up new theory is the information problem with market impact induced by large investors. Subsequently, the project achieved to show how the information environment drives economically important outcomes such as income inequality or the impact of foreign investors on market efficiency. From a micro-level perspective the project achieved to show how to identify private information in the market context and how to link this element to ex-ante trading decisions.

Over the reporting period, the project has been advanced along several dimensions. Below, I summarize the major steps that have been completed since the beginning period.

1. The project “Investor Sophistication and Capital Income Inequality” showed that access of individual households to information with different quality can spur the growth in capital income inequality which is an order of magnitude larger than that in labor income. This result is one of the first in the literature and definitely the first applied theory that connect the modeling framework to the data. The paper has been published at the Journal of Monetary Economics. The paper has already attracted a good number of citations and I believe it will continue on that path.

2. The project “Market Power and Price Informativeness” is still a work in progress. I have completed a major part of the theoretical component linking market power of traders to market efficiency. The model is now quite rich and delivers novel predictions regarding the role of active and passive investors in welfare formation and market efficiency. Nevertheless the study has managed to generate significant theoretical results on the theory of information in the presence of large investors. The main insights of the study is that the size of investors with market impact has a nonmontonic effect on price informativeness but the concentration has a strictly negative effect.

3. I have extended the price informativeness framework into an empirical work on the role of globalization in financial markets. The main result of the paper is that entry of foreign investors to stock markets improves price informativeness of stocks that benefit most from such entry. This is the new micro-level result in the international finance literature that allows us to think about the role of globalisation beyond aggregate outcomes as has been typically the case in the macroeconomic studies. The project has been published in the Review of Financial Studies.

"The big benefit of preparing the new draft of the project ""Market Power and Price Informativeness"" will be that the oligopolists are now going to internalize learning from each other unlike in the previous Cournot-type approach. This is a true example of the ERC project, a high risk, high reward project that gets shaped into a really good contribution.

The project on insider trading moves significantly our understanding of how informed investors trade and how they take into consideration legal risk associated with their trading. I have now generated a novel theoretical framework that illustrates how agents trade off the risk of losing information against the risk of legal enforcement from the perspective of their trading decision.

The project on globalization and capital market efficiency is taking a significant step to understand the role of globalization at the micro-level, both individually and at the firm level. The data and the framework are very conducive to this kind of exercise and I hope the project will improve our understanding of the role of globalization in society."

Periodic Reporting for period 3 - Endogenous_Info (Financial Decision Making with Endogenous Information Acquisition)

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