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In properly functioning asset markets, the price is supposed to reflect the available information. Even when someone has privileged information, the price is supposed to reflect that as well, as the person with better information will buy or sell until the price is right. What if there is disagreement participants? Is this a sign of risk that is rewarded, or are things just averaged out?
Bruce Carlin, Francis Longstaff and Kyle Matoba have access to information from Wall Street mortgage dealers about their estimates of mortgage prepayment speeds. Their disagreement changes over time and this allows to show that more disagreement leads to a positive risk premium. Also, uncertainty in itself (as measured by price volatility) does not leads to trade volume bursts, you also need more disagreement. All this means that traders do form rational expectations, in particular because higher trading volume subsequently leads to lower disagreement.
Bruce Carlin, Francis Longstaff and Kyle Matoba have access to information from Wall Street mortgage dealers about their estimates of mortgage prepayment speeds. Their disagreement changes over time and this allows to show that more disagreement leads to a positive risk premium. Also, uncertainty in itself (as measured by price volatility) does not leads to trade volume bursts, you also need more disagreement. All this means that traders do form rational expectations, in particular because higher trading volume subsequently leads to lower disagreement.
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