Information aggregation in financial markets
This dissertation consists of three essays on information aggregation in financial markets. The first essay develops a model to study the interplay between information aggregation in financial markets and a firm's investment decision. We find that dispersed information results in a wedge between the stock price and expected dividend value of the firm. When the investment decision of the firm is endogenous to the share price, the wedge is asymmetric: larger on the upside when there is a lot of investment (shares are over-valued), than on the downside when there is little investment (shares are under-valued). On average, the share price is over-valued. We discuss the role of tying managerial incentives to the firm's share price, finding that such incentives exacerbate asset over-valuation and introduce excess volatility and inefficiency in investment decisions. The second essay argues that the capacity of financial markets to aggregate information is diminished in times of distress, resulting in countercyclical economic uncertainty. I build a rational expectations equilibrium model in which financial intermediaries with private information become increasingly exposed to non-fundamental price fluctuations as funding constraints tighten during contractions. This reduces information-based trading and the informativeness of asset prices. Uncertainty spikes as conditions deteriorate due to amplification mechanisms that arise from the dispersed nature of information, and the presence of information externalities in a dynamic environment. I show that heightened uncertainty leads to increased risk premium, Sharpe ratio, and stock price volatility even when attitude towards risk and the unconditional volatility of fundamentals remain constant. The third essay combines the main insights of the first two. I incorporate funding constraints that limit informed trading to a larger extent when economic conditions are poor, resulting in stock prices that are less informative about the underlying fundamentals of a firm during contractions. I consider a profit function for the firm that exhibits partial irreversibilities of investment, yielding a desired investment level that depends negatively on uncertainty about fundamentals. Together, these results imply that investment will contract sharply at the outset of crises as not only expectations about fundamentals are lower, but uncertainty about them is also larger.