Information in stock prices and trading volume

In this thesis I develop two theoretical models to analyze how investors can infer private information from market prices and aggregate trading volume. In the first chapter I provide a closed form solution for a rational expectations equilibrium where all investors infer information about the state of the economy from (1) private signals, (2) the market price and (3) aggregate trading volume. The main result of this model is that trading volume reveals the relative quality of the aggregate private information in the economy. Investors use volume to decide how they should weight the market price relative to their own private signals when they update their beliefs. In the second chapter, I assume that investors make individual mistakes when they infer information from the price. I show that in a heterogeneous information economy, bounded rationality on the individual level is observationally equivalent to a psychological bias on the aggregate level. If the investors are not able to infer perfectly the true state of the economy from the price, then the aggregate demand corresponds to the demand of a representative agent who is "underconfident". The underconfidence of the representative agent causes the price to adjust to new information too slowly.