A Rational Expectations Equilibrium with Informative Trading Volume

Grossman (1976) shows how market prices aggregate private information. In this paper I show how trading volume helps investors to interpret the aggregate information in the price. I construct a model where investors trade for two reasons: private information and risk sharing. When trading volume is high, investors know that private signals are dispersed. They therefore weight the market price heavily relative to their own signals. Conversely, when trading volume is low, investors weight their private signals more heavily. This model offers a closed form solution of a rational expectations equilibrium where all investors learn from (1) private signals, (2) market price and (3) aggregate trading volume. ∗University of British Columbia. Please send any comments to [email protected]. I thank Alan Kraus for long discussions and many helpful comments. I also thank Adlai Fisher, Yoram Halevy and seminar participants at UBC.