As we observed in the Introduction, the purpose of this book is to discuss models of price formation that discard some of the assumptions of the traditional asset pricing approach. We shall start by removing the hypothesis of symmetric information and assess the relevance of adverse selection costs in asset pricing theory. To this end, after a brief introductory discussion of the importance of asymmetric information and the related new concept of rational expectations equilibrium, we start from a very simple model of asset pricing with symmetric information and then introduce models with asymmetric information, where prices are vehicles of information and where this role of prices is central to the analysis.

When traders use market prices to learn about the future value of an asset, by trading they affect the informational efficiency of the market, which ultimately depends on traders' preferences and the number and types of agents.

This chapter starts with a simple general framework in which a representative risk-averse agent allocates his wealth between a risk-free and a risky asset. The model is then extended to the case where the representative agent can choose to distribute his wealth among N risky assets; this will allow us to obtain the equilibrium asset prices that are consistent with the capital asset pricing model (CAPM) approach. Finally, we will introduce asymmetric information and show how equilibrium asset prices reflect public as well as private information.