Information Markets and the Comovement of Asset Prices

Traditional asset pricing models predict that covariance between prices of different assets should be lower than what we observe in the data. This model generates this high covariance within a rational expectations framework by introducing markets for information about asset payoffs. When information is costly, rational investors will not buy information about all assets; they will learn about a subset. Because information production has high fixed costs, competitive producers charge more for low-demand information than for high-demand information. A price that declines in quantity makes investors want to purchase a common subset of information. If investors price many assets using a common subset of information, then a shock to one signal is passed on as a common shock to many asset prices. These common shocks to asset prices generate `excess covariance.' The cross-sectional and time-series properties of asset price covariance are consistent with this explanation