250 REVIEW OF ECONOMIC STUDIES expectations about future cash flows and noise trading.When investors are less informed about the true growth rate of dividends,their expectation about future cash flows becomes less variable.This has the effect of reducing price volatility.On the other hand,there is more uncertainty in the stock's future cash flows.Investors demand higher premium in accommodating the noise trading and prices become more sensitive to supply shocks. This has the effect of increasing price volatility.The net change in price volatility depends on which of the two effects dominates.When noise trading is important,prices become more volatile as investors become less informed. Furthermore,we find that information asymmetry among investors can cause price volatility to increase.Under information asymmetry,more-informed investors trade on superior information against less informed investors.Hence,less-informed investors face an adverse selection problem when they respond to noise trading.They demand additional premium for the risk of trading against better informed investors.This results in increasing price elasticity to supply shocks and price volatility. Another application of our model revolves around the understanding of equity premia.We show that the existence of uninformed investors can lead to risk premia much higher than that under symmetric and perfect information.When more investors are less informed,prices contain less information about the fundamentals of the stocks. There is more uncertainty in the stocks'future cash flows(for the less-informed investors). Higher premia are required by the less informed investors to invest in stocks.Hence,as the fraction of uninformed investors in the economy increases the risk premia on stocks also increase. De Long et al.(1990)have suggested that noise trading in the market can increase price volatility,hence the risk of investing in the stock market and the risk premia.The key assumption that leads to their result is that some investors have finite investment horizons.The current model assumes an infinite horizon for all investors.It is shown that the unconditional expected excess returns on the stocks only depend on the risk in the stocks'future cash flows(the stocks'"fundamental risk").Even though noise trading does move prices and increase price volatility,without information asymmetry it does not affect the risk premia since it does not change stocks'fundamental risk.However, when there is information asymmetry in the market,noise trading will affect the informa- tion quality of prices in revealing private information about the stocks'future cash flows. More noise trading makes prices less informative about future dividend growth.This increases the uncertainty of future cash flows to the less informed investors,hence the required return.Therefore,in our model noise trading affect risk premia only under information asymmetry. Recent empirical studies suggest that there may exist significant negative serial correlation in long-horizon stock returns.Due to mean reversion in the underlying state variables that affect the expected excess returns,stock returns can be negatively serially correlated.However,when information asymmetry is present,the less-informed investors can only learn about these state variables from realized returns.This increases the dependence of their expected future returns on past returns and may enhance the negative serial correlation in stock returns. We also apply our model to analyze the trading strategies of investors with different information sets.When information asymmetry is present,the informed investors'stock 3.We do not explore the implications of information asymmetry on the connection between aggregate consumption and risk premia(see,for example,Grossman and Shiller(1981)and Mehra and Prescott(1985)). A discussion along this line would be more directly related to the Mehra-Prescott"equity premium puzzle". 4.See Fama and French(1987),Lo and MacKinlay(1988)and Poterba and Summers(1988)