ENDOGENOUS NOISE TRADERS (original) (raw)

Journal of Political Economy, 1990

We present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than do rational investors. The model sheds light on a number of financial anomalies, including the excess volatility of asset prices, the mean reversion of stock returns, the underpricing of closed end mutual funds, and the Mehra-Prescott equity premium puzzle.

Partially informed noise traders

Mathematics and Financial Economics, 2012

The single auction equilibrium of Kyle's (1985) is studied, in which noise traders may be partially informed, or alternatively they can be manipulated. Unlike Kyle's assumption that the quantity traded by the noise traders is independent of the asset value, we assume that the noise traders are able to correlate their trade with the true price. This has several implications for the equilibrium, one being that the insider's expected profits decrease as the noise traders' ability to correlate positively improve. In the limit, the noise traders do not lose on average, and the insider makes zero expected profits. When the correlation is negative, we interpret this as manipulation. In this case the insider makes the highest expected profits, and the informativeness of prices is at its minimum.

Dynamic noisy rational expectations equilibrium with insider information: Welfare and regulation

Journal of Economic Dynamics and Control, 2022

We study equilibria in multi-asset and multi-agent continuous-time economies with asymmetric information and bounded rational noise traders. We establish the existence of two equilibria. First, a full communication equilibrium where the informed agents' signal is disclosed to the market and static policies are optimal. Second, a partial communication equilibrium where the signal disclosed is affine in the informed and noise traders' signals, and dynamic policies are optimal. Here, information asymmetry creates demand for two public funds, as well as a dark pool where private information trades can be implemented. Markets are endogenously complete and equilibrium returns have a three factor structure with stochastic factors and loadings. Results are valid for constant absolute risk averse investors, general vector diffusions for fundamentals, nonlinear terminal payoffs, and non-Gaussian noise trading. Asset price dynamics and public information flows are endogenous, and rational expectations equilibria are special cases of the general results.

Dynamic Noisy Rational Expectations Equilibrium with Information Production and Beliefs-Based Speculation

Social Science Research Network, 2016

Asymmetric information and survival in financial markets

Economic Theory, 2005

In the evolutionary setting for a …nancial market developed by , we consider an in…nitely repeated version of a model à la with asymmetrically informed traders. Informed traders observe the realisation of a payo¤ relevant signal before making their portfolio decisions. Uninformed traders do not have direct access to this kind of information, but can partially infer it from market prices. As a counterpart for their privileged information, informed traders pay a per period cost. As a result, information acquisition triggers a trade-o¤ in our setting. We prove that, as long as information is costly, a strictly positive measure of uninformed traders will survive. This result contributes to the literature on noise trading. It suggests that Friedman (1953)'s argument against the importance of noise traders in the process of price determination is too simplistic. Traders whose beliefs are "wrong" according to the best available information, in fact, are not wiped out by market forces and do a¤ect asset prices in the long run.

Trading Under Uncertainty About Other Market Participants

SSRN Electronic Journal, 2019

I present an asymmetric information model of financial markets that features rational, but uninformed, hedge fund managers who trade against informed and noise traders. Managers are uncertain not only about fundamentals, but also about the proportion of informed to noise traders in the market and use prices to update their beliefs about these uncertainties. Extreme news leads to an increase in both types of uncertainty, while it decreases price informativeness. Prices react asymmetrically to positive and negative news, with higher expected returns at times of increased uncertainty about market composition. The model generates a pricevolume relationship that is consistent with established stylized facts. I then extend to a three-period model and study the dynamics of expected returns and volatility.

Speculation and price fluctuations with private, extrinsic signals

Journal of Economic Theory, 1991

We consider an overlapping generations model in which asset prices are determined through a Vickrey auction. The existence of speculative (sunspot) equilibria is proven, where traders strictly prefer to act based on private, nonfundamental signals. An example is presented in which speculation over “market psychology” nearly drives fundamental analysis (inside information about dividends) out of the market. Another example demonstrates price fluctuations that persist as the number of traders approaches infinity. The equilibria produce price fluctuations without any trader able to identify the source; we informally argue that the model sheds light on the phenomenon of technical analysis.

Noise, equity prices, and hedging: A new approach

International Review of Financial Analysis, 2008

The existence of noise trading in equity markets has possible economic implications for arbitrage, and asset pricing. In terms of pricing, noise trading can lead to excess volatility which has been shown to influence the value of options and futures. Furthermore, option research shows that modeling volatility leads to improved hedging performance. To this end, we derive a general hedging model for equity index futures in the presence of noise trading. Our analysis shows how the level and dynamics of noise trading should influence a hedger's behavior. Finally, we empirically test our model using the NASDAQ-100 index futures and FTSE 100 index futures over the period of

Informed traders

Proceedings of the Royal Society A: Mathematical, Physical and Engineering Sciences, 2008

An asymmetric information model is introduced for the situation in which there is a small agent who is more susceptible to the flow of information in the market than the general market participant, and who tries to implement strategies based on the additional information. In this model market participants have access to a stream of noisy information concerning the future return of an asset, whereas the informed trader has access to a further information source which is obscured by an additional noise that may be correlated with the market noise. The informed trader uses the extraneous information source to seek statistical arbitrage opportunities, while at the same time accommodating the additional risk. The amount of information available to the general market participant concerning the asset return is measured by the mutual information of the asset price and the associated cash flow. The worth of the additional information source is then measured in terms of the difference of mutu...

Endogenous informed trading in the presence of trading costs: Theory and evidence

Journal of Financial Markets, 1999

The basic premise of the model we propose is that market frictions (trading costs) force traders with market-wide information to strategically choose which securities to trade in. We study the e!ect of recognizing trading costs on the choices of informed traders and the resulting statistical properties of security prices. Speci"cally, we show that (1) stocks with intermediate 's have the least informative prices, even though they are traded by the greatest number of informed traders; (2) for high securities, the contemporaneous correlation of prices is close to the correlation in fundamental values; (3) a security with a higher , higher volume of liquidity trading and lower idiosyncratic variance is more likely to lead another security. With market capitalization as a proxy for the level of liquidity trading, these speci"c predictions of the model on the lead}lag relationship are also shown to be strongly supported by the data.

ENDOGENOUS NOISE TRADERS (original) (raw)

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