Information Asymmetry , Diversification , and Cost of Capital ∗ †

Recently, there has been considerable interest among accounting researchers in the relation between asymmetric information and cost of capital. A number of empirical studies document associations between proxies for asymmetric information such as earnings quality and risk premiums. However, the theoretical foundation for these studies has yet to be fully established. In this study, we consider the effects of private signals that are informative of both systematic factors and idiosyncratic shocks affecting asset payoffs in a competitive noisy rational expectations setting. Taking a large economy limit, we show that i) risk premiums equal products of betas and factor risk premiums, irrespective of information asymmetries; ii) holding total information constant, greater information asymmetry leads to higher factor risk premiums and thus higher costs of capital; and iv) controlling for betas, there is no cross-sectional effect of information asymmetries on cost of capital. These results provide guidance in interpreting the findings of existing empirical work and suggest specifications helpful for future research.