Information Asymmetry, Information Precision, and the Cost of Capital*

Abstract

This paper examines the relation between information differences across investors (i.e., information asymmetry) and the cost of capital and establishes that with perfect competition information asymmetry makes no difference. Instead, a firm's cost of capital is governed solely by the average precision of investors' information. With imperfect competition, however, information asymmetry affects the cost of capital even after controlling for investors' average precision. In other words, the capital market's degree of competition plays a critical role for the relation between information asymmetry and the cost of capital. This point is important to empirical research in finance and accounting. AbstractThe consequences of information differences across investors in capital markets are still much debated. This paper examines the relation between information differences across investors and the cost of capital. Our analysis makes three salient points. First, in models of perfect competition, information differences across investors affect a firm's cost of capital through investors' average information precision, and not information asymmetry per se. Second, the average information precision effect is unlikely to diversify away when there exist many firms whose cash flows covary. Finally, in models of imperfect competition information asymmetry affects the willingness to supply liquidity; this, in turn, affects a firm's cost of capital. Thus, the precision of the information and information asymmetry have separate and distinct effects on the cost of capital. Failure to distinguish between them jeopardizes our understanding of the link between information and the cost of capital.JEL classification: G12, G14, G31, M41

The effect of conservatism on cost of capital: MENA evidence

“…As shown by Guay and Verrecchia (2007), this is achieved by improving contracting efficiency and reducing agency and litigation costs. These results are consistent with the work of Lambert et al (2007Lambert et al ( , 2011, who demonstrate that improving the quality of accounting information increases the precision with which actors in the market can estimate the real firm value and, thus reduce the cost of equity capital.…”

“…For example, Gietzmann and Trombetta (2003) articulate that conservatism acts as a substitute of voluntary disclosure. Given that a body of studies has established that the manager's commitment to voluntary disclosure process reduces the cost of equity capital by decreasing investors' information risk Verrecchia, 1981, 1991;Botosan, 1997Botosan, , 2006Botosan and Plumlee, 2002;Easley and O'Hara, 2004;Francis et al, 2004;Hail and Leuz, 2007;Lambert et al, 2011). Therefore, we presume that accounting conservatism should reduce the cost of equity capital.…”

“…Given that voluntary disclosure reduces the cost of equity capital as documented by much empirical research (e.g. Verrecchia, 1981, 1991;Botosan, 1997Botosan, , 2006Botosan and Plumlee, 2002;Easley and O'Hara, 2004;Francis et al, 2004;Hail and Leuz, 2007;Lambert et al, 2011), we assume that accounting conservatism can have the same effect, that is, reducing the cost of equity capital. Another result was developed by Bagnoli and Watts (2005).…”

A PIN per day shows what news convey: the intraday probability of informed trading

“…And the increase of informed trading despite the public release of information could be due to the additional private information required to correctly interpret the news. Lambert et al (2012) argue that what we refer to as ''just'' information asymmetry actually consists of two concepts, information asymmetry and average information precision. Both concepts are highly related but may move in opposite directions and are difficult to distinguish empirically.…”

Study of market model describing the contrary behaviors of informed and uninformed agents: Being minority and being majority

“…In each time step, all agents choose '0'(such as 'buy') with a probability g, and '1' (such as 'sell') with a probability 1 − g. After all the agents have made a choice, one can obtain the number of un-agents who choose the '0' or the '1' actions, as well as the number of in-agents who choose the '0' or the '1' actions. An un-agent is rewarded with one point r = 1 if she chooses the majority choice of the in-agents, and otherwise loses one point r = −1 [22][23][24]. On the other hand, an in-agent is rewarded with one point r = 1 if she chooses the minority choice of the un-agents and otherwise she loses one point r = −1.…”