Essays on asset pricing with incomplete or noisy information

Abstract

This dissertation consists of two essays, in which I examine the effects of incomplete or noisy information on expected risk premium in equity markets. In the first essay I provide empirical evidence demonstrating that an information-quality (IQ) factor, built on accrual-based information precision measure, is priced. This result still stands after controlling for factors, such as size, Book-to-Market (B/M) ratio, and liquidity. To explain this empirical observation, I derive a continuous-time model in the spirit of Merton’s (1973) Intertemporal Capital Asset Pricing Model (ICAPM) to examine how systematic IQ risk affects security returns. Unique to my model, imprecise information influences the pricing of an asset through its covariance with: (i) stock return; (ii) market return; and (iii) market-wide IQ. In equilibrium, the aggregate effect of these covariance terms (proportional to IQ-related betas) represents the systematic component of IQ risk and therefore requires a risk premium to compensate for it. My empirical test confirms that the aggregate effect of systematic IQ risk is significant and robust to the inclusion of other risk sources, such as liquidity risk. In the second essay I extend a recent complete information stock valuation model with incomplete information environment. In practice, mean earnings-per-share growth rate (MEGR) is random and unobservable. Therefore, asset prices should reflect how investors learn about the unobserved state variable. In my model investors learn about MEGR in continuous time. Firm characteristics, such as stronger mean reversion and lower volatility of MEGR, make learning faster and easier. As a result, the magnitude of risk premium due to uncertainty about MEGR declines over learning horizon and converges to a long-term steady level. Due to the stochastic nature of the unobserved state variable, complete learning is impossible (except for cases with perfect correlation between earnings and MEGR). As a result, the risk premium is non-zero at all times reflecting a persistent uncertainty that investors hold in an incomplete information environment.