We investigate the role of information in affecting a firm's cost of capital. We show that differences in the composition of information between public and private information affect the cost of capital, with investors demanding a higher return to hold stocks with greater private information. This higher return arises because informed investors are better able to shift their portfolio to incorporate new information, and uninformed investors are thus disadvantaged. In equilibrium, the quantity and quality of information affect asset prices. We show firms can inf luence their cost of capital by choosing features like accounting treatments, analyst coverage, and market microstructure.FUNDAMENTAL TO A VARIETY OF CORPORATE DECISIONS is a firm's cost of capital. From determining the hurdle rate for investment projects to inf luencing the composition of the firm's capital structure, the cost of capital inf luences the operations of the firm and its subsequent profitability. Given this importance, it is not surprising that a wide range of policy prescriptions has been advanced to help companies lower this cost. For example, Arthur Levitt, the former chairman of the Securities and Exchange Commission, suggests that "high quality accounting standards . . . improve liquidity [and] reduce capital costs."1 The Nasdaq stock market argues that its trading system "most effectively enhances the attractiveness of a company's stock to investors." 2 And investment banks routinely solicit underwriting business by arguing that their financial analysts will lower a company's cost of capital by attracting a greater institutional following to the stock. While accounting standards, market microstructure, and financial analysts each clearly differ, these factors can all be thought of as inf luencing the information structure surrounding a company's stock. 3 Paradoxically, asset-pricing models include none of these factors in determining the required return for a company's stock. While more recent asset-pricing * Both authors are at Cornell University. We would like to thank an anonymous referee,

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We investigate the role of information-based trading in affecting asset returns. We show in a rational expectation example how private information affects equilibrium asset returns. Using a market microstructure model, we derive a measure of the probability of information-based trading, and we estimate this measure using data for individual NYSE-listed stocks for 1983 to 1998. We then incorporate our estimates into a Fama and French~1992! asset-pricing framework. Our main result is that information does affect asset prices. A difference of 10 percentage points in the probability of information-based trading between two stocks leads to a difference in their expected returns of 2.5 percent per year.ASSET PRICING IS FUNDAMENTAL to our understanding of the wealth dynamics of an economy. This central importance has resulted in an extensive literature on asset pricing, much of it focusing on the economic factors that inf luence asset prices. Despite the fact that virtually all assets trade in markets, one set of factors not typically considered in asset-pricing models are the features of the markets in which the assets trade. Instead, the literature on asset pricing abstracts from the mechanics of asset price evolution, leaving unsettled the underlying question of how equilibrium prices are actually attained.Market microstructure, conversely, focuses on how the mechanics of the trading process affect the evolution of trading prices. A major focus of this extensive literature is on the process by which information is incorporated into prices. The microstructure literature provides structural models of how prices become efficient, as well as models of volatility, both issues clearly of importance for asset pricing. But of perhaps more importance, microstructure models pro-

This article investigates whether differences in information‐based trading can explain observed differences in spreads for active and infrequently traded stocks. Using a new empirical technique, we estimate the risk of information‐based trading for a sample of New York Stock Exchange (NYSE) listed stocks. We use the information in trade data to determine how frequently new information occurs, the composition of trading when it does, and the depth of the market for different volume‐decile stocks. Our most important empirical result is that the probability of information‐based trading is lower for high volume stocks. Using regressions, we provide evidence of the economic importance of information‐based trading on spreads.

This paper investigates the informational role of transactions volume in options markets. We develop an asymmetric information model in which informed traders may trade in option or equity markets. We show conditions under which informed traders trade options, and we investigate the implications of this for the linkage between markets. Our model predicts an important informational role for the volume of particular types of option trades. We empirically test our model's hypotheses with intraday option data. Our main empirical result is that negative and positive option volumes contain information about future stock prices. THE INFORMATION CONTENT of trading activity is a subject of widespread interest. If trades are correlated with private information, then the outcome of the transaction process may portend future movements in price. The extension of trading to different venues or to derivative instruments, however, means that this link between transactions and information need not be easily discernible. If there are alternative markets in which informed traders can profit from their information, then where informed traders choose to trade may have important implications not only for security price movements, but for the behavior of related prices as well. This suggests that transactions in derivative markets may be an important predictor of future security price movements.In this paper we investigate the informational role of transactions volume in options markets. For some readers, this focus may seem puzzling; an option is a derivative security so its price should be dictated unilaterally by the behavior of the stock price. This unidirectional linkage is only true, however, in complete markets; if information is impounded into prices by trading, then the ability of informed traders to transact in options markets means