Fundamental volatility and informative trading volume in a rational expectations equilibrium

This paper presents a tractable model of asset price with informative trading volume. Investors condition demands on their rational expectations of both the equilibrium price and trading volume. We suggest a new information role of trading volume, which enables the investors to extract continuous information regarding the liquidation value volatility of the risky asset. The liquidation value volatility determines the relative importance of fundamental value and noise trading in the price function. It also monotonically increases the price volatility. We provide an explanation of the negative and nonlinear relationship between price volatility and trading volume. We also examine the effects of information accuracy and investor composition on the equilibrium price distribution and trading volume. • Investors rationally expect both price and trading volume under market equilibrium. • Trading volume reveals the fundamental volatility of the risky asset. • Fundamental volatility weighs fundamental value against noise trading in pricing. • Negative and nonlinear relation exists between price volatility and trading volume. • A non-monotonic relation exists between price volatility and information accuracy.