1 Information, Equilibrium, and Efficiency Concepts
Financial markets are driven by news and information. The standard asset pricing theory assumes that all market participants possess the same information. However, in reality different traders hold different information. Some traders might know more than others about the same event or they might hold information related to different events. Even if all traders hear the same news in the form of a public announcement, they still might interpret it differently. Public announcements only rarely provide a direct statement of the value of the asset. Typically one has to make use of other information to figure out the impact of this news on the asset's value. Thus, traders with different background information might draw different conclusions from the same public announcement. Therefore, financial markets cannot be well understood unless one also examines the asymmetries in the information dispersion and assimilation process.In economies where information is dispersed among many market participants, prices have a dual role. They are both:
|• an index of scarcity or bargaining power, and|
|• a conveyor of information.|
Hayek (1945) was one of the first to look at the price system as a mechanism for communicating information. This information affects traders' expectations about the uncertain value of an asset. There are different ways of modeling the formation of agents' expectations. Muth (1960 , 1961) proposed a rational expectations framework which requires people's subjective beliefs about probability distributions to actually correspond to objective probability distributions. This rules out systematic forecast errors. The advantage of the rational expectations hypothesis over ad hoc formulations of expectations is that it provides a simple and plausible way of handling expectations. Agents draw inferences from all available information derived from exogenous and endogenous data. In particular, they infer information from publicly observable prices.