Can Market Risk Perception Drive to Inefficient Prices? Theory and Evidence

This work presents an asset pricing model of informed investors with constant absoluterisk aversion (CARA) utility functions who trade with liquidity investors when prices and dividends are normally distributed. Adopting a competitive rational expectation equilibrium perspective, we find that the model shows two types of unique linear equilibrium price: the informationally semi-strong efficient price, similar to the original model of Campbell and Kyle (1993), and the completely informationally inefficient prices. We argue that the former Pareto dominates (is dominated by) the latter in the presence of low (high) market risk perception measured by risk aversion and market microstructure variance. The estimates of the model using real data confirm our theoretical findings. The S&P 500 Index is informationally efficient during 1871–2009, and inefficient in the sub-period 1995–2000.