How Does Information Quality Affect Stock Returns

TLDR: In this paper, the authors investigated the relationship between the precision of public information about economic growth and stock market returns and showed that higher precision of signals tends to increase the risk premium, when signals are imprecise, and return volatility is U-shaped with respect to investors' risk aversion.

Abstract: Using a simple dynamic asset pricing model, this paper investigates the relationship between the precision of public information about economic growth and stock market returns. After fully characterizing expected returns and conditional volatility, I show that (i) higher precision of signals tends to increase the risk premium, (ii) when signals are imprecise the equity premium is bounded above independently of investors' risk aversion, (iii) return volatility is U-shaped with respect to investors' risk aversion, and (iv) the relationship between conditional expected returns and conditional variance is ambiguous. IN MODERN FINANCIAL MARKETS, investors are flooded with a variety of information: corporations' earnings reports, revisions of macroeconomic indexes, policymakers' statements, and political news. These pieces of information are processed by investors to update their projections of the economy's future growth rate, inflation rate, and interest rate. In turn, these changes in investors' expectations affect stock market prices. However, even though it is clear that asset prices react to new information, several questions arise regarding the relationship between the quality of information that investors receive and asset returns. For example, what kind of effect does a noisy signal on the "health" of the economy have on stock market prices? If information is noisy, is there a risk premium? Or is the risk premium completely independent of the quality of information investors receive? Also, how does the precision of the signals affect stock market volatility? If signals are more precise, does stock market volatility decrease or increase? Finally, can we infer how good investors' information is from the behavior of stock market returns? In this paper I study a dynamic asset pricing model where I try to answer the above questions. Specifically, I assume that stock dividends are generated by a diffusion process whose drift rate is unknown to investors and may