Dynamic Market Participation and Endogenous Information Aggregation

A dynamic general equilibrium model of asset trading with private information and collateral constraints is considered. Investors differ in their aversion to Knightian uncertainty: When uncertainty is high, some investors exit the market. Since exiting investors' information is not fully revealed by prices, conditional return volatility and risk premia both increase. Data on institutional investors' holdings of individual stocks show that investor exits indeed move negatively with price informativeness. The model also implies that exit is more likely when wealth is more concentrated in the hands of less uncertainty-averse investors. The model thus predicts less informative prices toward the end of a long boom, as seen in the data. Moreover, economies with looser collateral constraints should see more volatility due to exit and partial revelation. Higher capital requirements can improve welfare by inducing more information revelation by prices.