Testing Financial Market Equilibrium under Asymmetric Information

Larry H. P. Lang
New York University
Robert H. Litzenberger
University of Pennsylvania
Vicente Madrigal
New York University
We devise tests that distinguish between competitive (Walrasian),
fully revealing rational expectations and noisy rational expectations
equilibria based on their predictions concerning trading volume
around public information signals. Empirical results strongly support
the noisy rational expectations hypothesis. This indicates that
a significant amount of noise exists (so that private information has
value), but not enough to obfuscate entirely the information content
of price. Our analysis also indicates that the dispersion of private
information across traders has an impact on trading volume, but
not on price.

I. Introduction
The proposition that differences in opinion make a horse race now
has strong analytical support. In financial markets, divergent beliefs
arising from asymmetric information play an important role in generating
activity. Without these divergent beliefs, speculative trading in
assets would not exist (see Milgrom and Stokey 1982; Varian 1985).
These results have spawned (and are a product of) the significant
theoretical progress in the analysis of markets in which investors have
heterogeneous information.' However, no empirical research has yet
studied which equilibrium concept is most appropriate in modeling
these markets. This issue is significant because the choice of equilibrium
notion determines the model's predictive outcomes. This paper
is an attempt to take a first step in resolving this problem.