A Bayesian understanding of information uncertainty and the cost of capital
Lambert et al . (2007, p 386) describe the connection between information and the cost of capital as one of the most fundamental issues in markets. They quote a former Chairman of the Securities and Exchange Commission (SEC) who held that 'more information always equates to less uncertainty', and that better accounting disclosure (e.g. higher 'earnings quality') results in a lower cost of capital. Whilst this claim points to a potentially valuable role for financial reporting, Lambert et al. (2007) call for a deeper theoretical understanding of the benefits of improved accounting information in asset pricing. The purpose of my chapter is to specify probabilistic notions of 'information' and 'information quality' and to clarify from a general Bayesian perspective how the attributes of financial information influence rational asset prices. My results are fundamentally contrary to conventional wisdom especially in regard to the mechanics of information reducing the cost of capital.
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