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Noise, equity prices, and hedging: A new approach

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  • Bertus, Mark
  • Godbey, Jonathan
  • Hinkelmann, Christoph
  • Mahar, James W.
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    Abstract

    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 January 1998 to May 2003.

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    File URL: http://www.sciencedirect.com/science/article/B6W4W-4T8JXJJ-1/2/1a753a1cc6f63af72af149c08eccf296
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    Bibliographic Info

    Article provided by Elsevier in its journal International Review of Financial Analysis.

    Volume (Year): 17 (2008)
    Issue (Month): 5 (December)
    Pages: 886-902

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    Handle: RePEc:eee:finana:v:17:y:2008:i:5:p:886-902

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    Web page: http://www.elsevier.com/locate/inca/620166

    Related research

    Keywords: Hedging Noise trading Asset pricing;

    References

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    1. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
    2. Bakshi, Gurdip & Cao, Charles & Chen, Zhiwu, 1997. " Empirical Performance of Alternative Option Pricing Models," Journal of Finance, American Finance Association, vol. 52(5), pages 2003-49, December.
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    4. Markus K. Brunnermeier & Stefan Nagel, 2004. "Hedge Funds and the Technology Bubble," Journal of Finance, American Finance Association, vol. 59(5), pages 2013-2040, October.
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    7. Markus K Brunnermeier, 2002. "Bubbles and Crashes," FMG Discussion Papers dp401, Financial Markets Group.
    8. Neal, Robert, 1996. "Direct Tests of Index Arbitrage Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 31(04), pages 541-562, December.
    9. Black, Fischer, 1986. " Noise," Journal of Finance, American Finance Association, vol. 41(3), pages 529-43, July.
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    14. Charles Quanwei Cao & Gurdip S. Bakshi & Zhiwu Chen, 1997. "Empirical Performance of Alternative Option Pricing Models," Yale School of Management Working Papers ysm65, Yale School of Management.
    15. Jeremy J. Siegel, 2003. "What Is an Asset Price Bubble? An Operational Definition," European Financial Management, European Financial Management Association, vol. 9(1), pages 11-24.
    16. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, vol. 53(5), pages 1775-1798, October.
    17. Eli Ofek & Matthew Richardson, 2002. "The Valuation and Market Rationality of Internet Stock Prices," Oxford Review of Economic Policy, Oxford University Press, vol. 18(3), pages 265-287.
    18. Merrick, John J., 1988. "Hedging with Mispriced Futures," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(04), pages 451-464, December.
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