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Price Impact and Survival of Irrational Traders

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  • Leonid Kogan

    (Sloan School of Management, MIT and NBER)

  • Stephan Ross

    (Sloan School of Management, MIT and NBER)

  • Jiang Wang

    (Sloan School of Management, MIT and NBER)

  • Mark Westerfield

    (Economics Department, MIT)

Abstract

Milton Friedman argued that irrational traders will consistently lose money, won’t survive and, therefore, cannot influence long run equilibrium asset prices. Since his work, survival and price impact have been assumed to be the same. In this paper, we demonstrate that survival and price impact are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. We also show that irrational traders ’portfolio policies can deviate from their limits long after the price process approaches its long-run limit. We show, in contrast to a partial equilibrium analysis, these general equilibrium considerations matter for the irrational traders long-run survival. In sum, we explicitly show that price impact can persist whether or not the irrational traders survive.

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Bibliographic Info

Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp116.

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Date of creation: Oct 2004
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Handle: RePEc:fam:rpseri:rp116

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  1. Leonid Kogan & Stephen A. Ross & Jiang Wang & Mark M. Westerfield, 2006. "The Price Impact and Survival of Irrational Traders," Journal of Finance, American Finance Association, vol. 61(1), pages 195-229, 02.
  2. Susan Athey, 2002. "Monotone Comparative Statics Under Uncertainty," The Quarterly Journal of Economics, MIT Press, vol. 117(1), pages 187-223, February.
  3. Jiang, Wang, 1996. "The term structure of interest rates in a pure exchange economy with heterogeneous investors," Journal of Financial Economics, Elsevier, vol. 41(1), pages 75-110, May.
  4. Radner, Roy, 1972. "Existence of Equilibrium of Plans, Prices, and Price Expectations in a Sequence of Markets," Econometrica, Econometric Society, vol. 40(2), pages 289-303, March.
  5. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1991. "The Survival of Noise Traders in Financial Markets," Scholarly Articles 3725470, Harvard University Department of Economics.
  6. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  7. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, vol. 53(5), pages 1775-1798, October.
  8. Athey, Susan, 2002. "Monotone Comparative Statics Under Uncertainty," Scholarly Articles 3372263, Harvard University Department of Economics.
  9. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
  10. Hakansson, Nils H., 1971. "Capital Growth and the Mean-Variance Approach to Portfolio Selection," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 6(01), pages 517-557, January.
  11. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  12. Alvaro Sandroni, 2000. "Do Markets Favor Agents Able to Make Accurate Predicitions?," Econometrica, Econometric Society, vol. 68(6), pages 1303-1342, November.
  13. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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