Noise Trader

Noise Trader

Po-Keng Cheng (State University of New York, Stony Brook University, USA)
DOI: 10.4018/978-1-5225-2255-3.ch006
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Abstract

This paper briefly reviews the literature on the topics of noise traders in the financial market. We cover the no-trade theorem under complete and competitive markets in the 1980s, the noise trader approach to finance in the 1990s, and recent studies from several approaches related to noise traders, such as heterogeneous agent models, investor sentiment, retail investors, experimental analysis, and extrapolation. Understanding and tackling the issues resulted from noise traders would be essential for us to realize how financial and economic markets work.
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Background

Lucas’ asset pricing model (Lucas, 1978) suggests asset prices are the discounted value of dividends with time preferences. The asset price (Krusell, 2007) is equal to

, where represents for consumer's time preference, is consumer's marginal utility function, is the endowment consumer received at time period t, and is the dividend asset paid at time period t. But in the real world, the fluctuations of asset prices in the financial market are far greater to be explained by changes in dividends (Shiller, 1981), suggesting the asset prices are affected by more than fundamentals (Shiller, 2003).

Harrison and Kreps (1978) argued that heterogeneous expectations on dividends policy may cause the price of stock to differ from its fundamental value. De Long, Shleifer, Summers, and Waldmann (1990b) provided a theoretical basis for the noise trader approach. They proposed that the existence of noise traders could lead to divergences between market prices and fundamental values. Additionally, they suggested that some financial anomalies, like the excess volatility of asset prices, the mean reversion of stock return, and the equity premium puzzle could be explained by noise trader risk. Another paper (De Long, Shleifer, Summers, & Waldmann, 1990a) by the same authors suggested that with the presence of positive-feedback investors, rational arbitrageurs’ early positions trigger positive-feedback trading which drives asset prices away from fundamentals. Cutler, Poterba, and Summers (1990, 1991) formalized the role of feedback traders and presented evidences on the characteristic speculative dynamics of returns across markets. Frankel and Froot (1990, 1991) proposed the forecast models of chartists and fundamentalists in which portfolio managers place different weights on chartist and fundamentalist views, explaining the appreciation of the US dollar in 1981–1985.

Key Terms in this Chapter

No-Trade Theorem: Suppose traders in the market are risk-averse and fully rational. If the initial allocation of resources is Pareto-optimal, then private information received by an individual trader will not cause trade, see Milgrom and Stokey (1982) for more details.

Positive-Feedback Investor: Traders who buy when prices rise and sell when prices fall.

Fundamentalist: Traders who believe the existence of fundamental values and trade based on their expectations of fundamentals.

Fully Rational: Agents who are rational with common knowledge that equilibrium trade is feasible and each agent is rational.

Pareto-Optimal: A feasible allocation is Pareto-optimal if there is no other feasible allocation which makes some individuals better off without making some individuals worse off.

Heterogeneous Belief: Agents have different expectations for the state of future. Traders with heterogeneous beliefs have different price beliefs for next periods' prices in the financial market.

Common Knowledge: An event E is common knowledge if E is known by each agent in a group, if each agent knows that E is known by each of them, if each agent knows that each agent knows that E is known by each of them, and so on.

Equity Premium Puzzle: A phenomenon observed by Mehra and Prescott (1985) that the average returns of equity are higher than those of Treasury bills in the U.S. data during the period of 1889 to 1978.

Agree to Disagree: A question discussed in Aumann (1976) . If two agents have the same priors and their posteriors for an event are common knowledge, then these posteriors will be the same. That is, these two agents cannot agree to disagree.

Rational: Agents who have von Neumann-Morgenstern preferences.

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