The no-arbitrage condition and financial markets with heterogeneous and costly information

Abstract

The explosion of the rational expectations equilibrium models in the finance literature has occurred when the perfect market assumption of homogeneous information is relaxed and prices play the role of aggregating and transmitting information in the financial market. This paper shows that the no-arbitrage condition in a financial market with heterogeneous and costly information is equivalent to the existence of a pricing operator. It is further shown that equilibrium prices in financial markets with heterogeneous and costly information are, in fact, equilibrium prices in a perfect market plus a certain factor. This paper then shows the functional relation between this certain factor and the form of the information-cost function. In this way, the results of Ross (1978), Gaman and Ohlson (1981), and Dermody and Prisman (1993) are extended to financial markets with heterogeneous and costly information.