Information Asymmetry, Non-Learnable Payoff and the Cost of Capital

Abstract

This paper examines the roles of information differences among informed investors (information asymmetry) in the determination of a firm's cost of capital and price informativeness when the risky asset payoff contains a non-learnable component. The existence of non-learnable payoff disproportionately decreases the information advantage of more informed traders, relative to less informed traders, leading asset prices to be affected by both the aggregate information precision and information asymmetry among investors. As a result, a higher level of information asymmetry decreases price informativeness and increases cost of capital. In an economy with multiple assets, information asymmetry from the market factor affects the costs of capital of all risky assets, but information asymmetry from the firm specific factor only affects the cost of capital of that particular firm.