PDF Ebook Cost of Capital in Imperfect Competition Settings
This paper analyzes the role of information in pricing and cost of capital in security markets characterized by imperfect competition: that is, in markets that are less than perfectly liquid. Standard setters and policy makers often claim that high-quality information and a level playing field are essential to the efficient allocation of capital in the economy. For example, Robert Herz, chairman of the Financial Accounting Standards Board states: “It’s about lowering the cost of capital, lowering the cost of preparation, and lowering the cost of using it,” (see Wild, 2004). Similarly, Arthur Leavitt, former chairman of the Securities and Exchange Commission, argues that “high quality accounting standards ... improve liquidity [and] reduce capital costs,” (see Leavitt, 1997).
Yet information issues are largely absent in conventional models of asset pricing and cost of capital. For example, in a Capital Asset Pricing Model (CAPM) framework, all investors are presumed to have homogeneous information, so issues that arise from information asymmetry are precluded from occurring. Moreover, only non-diversifiable risk is priced, and the relevant non-diversifiable risk is the covariance of the firm’s cash flows with the market. Therefore, the only way information can affect cost of capital is through its impact on this covariance. In noisy rational expectations models (e.g., Grossman and Stiglitz, 1980; Hellwig, 1980; Diamond and Verrecchia, 1981), heterogeneous information plays a prominent role, and the aggregation of this information through price is an important part of the analysis. The literature finds, however, that only the average precision of investors’ information matrices (e.g, the inverse of their assessed covariance matrices) is relevant in deriving the equilibrium cost of capital (see, e.g., Lintner,1969; Admati, 1985; and Lambert, Leuz, and Ver-recchia, 2009). Information asymmetry across investors can affect cost of capital, but only through its effect on investors’ average precision. Controlling for average precision, the degree of information asymmetry across investors (e.g., the amount that investors’ information precisions differ from the average) does not affect cost of capital.
As discussed in Merton (1989) and O’Hara (2003), one feature that the above theoretical models have in common is that they assume market prices are based on perfect competition. That is, all investors act as price takers, and they can buy and sell any quantity at the market price: markets are perfectly liquid.1 In contrast, imperfect competition and asymmetric information are common features of market microstructure models going back to Kyle (1985) and Glosten and Milgrom (1985). Moreover, these models find that information asymmetry can affect market features such as bid-ask spreads.
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PDF Ebook Cost of Capital in Imperfect Competition Settings
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