Is Information Risk a Determinant of Asset Returns?

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.