Information Percolation Driving Volatility

Abstract Sudden big price changes are followed by periods of high and persistent volatility. I develop a tractable dynamic rational expectations model consistent with this observation. An infinity of agents possess dispersed information about future dividends and trade in centralized markets. Information is processed, transmitted, and aggregated in two ways: (i) agents meet randomly and exchange information through word-of-mouth communication, and (ii) the price aggregates information through the trading process. Both mechanisms operate simultaneously to generate high and persistent volatility. The resulting information flow drives both returns and volume. The short-term asset, defined as the claim to immediate future dividends, becomes more volatile. The pronounced heterogeneity in investors' information endowments induces patterns of trade consistent with empirical findings. These results serve as a road sign indicating the central role played by word-of-mouth communication in financial markets