We consider a model of the stock market with delegated portfolio management. All agents are rational: some trade for hedging reasons, some investors optimally contract with portfolio managers who may have stock-picking abilities, and portfolio managers trade optimally given the incentives provided by this contract. Managers try, but sometimes fail, to discover profitable trading opportunities. Although it is best not to trade in this case, their clients cannot distinguish 'actively doing nothing,' in this sense, from 'simply doing nothing.' Because of this problem: (i) some portfolio managers trade even though they have no reason to prefer one asset to another (noise trade). We also show that, (ii), the amount of such noise trade can be large compared to the amount of hedging volume. Perhaps surprisingly, (iii), noise trade may be Pareto-improving. Noise trade may be viewed as a public good. Results (i) and (ii) are compatible with observed high levels of turnover in securities markets. Result (iii) illustrates some of the possible subtleties of the welfare economics of financial markets.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
4858.
Length: Date of creation: Sep 1994 Date of revision: Handle: RePEc:nbr:nberwo:4858
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Find related papers by JEL classification: G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data) G23 - Financial Economics - - Financial Institutions and Services - - - Pension Funds; Other Private Financial Institutions
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990.
"Noise Trader Risk in Financial Markets,"
Journal of Political Economy,
University of Chicago Press, vol. 98(4), pages 703-38, August.
[Downloadable!] (restricted)
Other versions:
Dow, James & Gorton, Gary, 1994.
" Arbitrage Chains,"
Journal of Finance,
American Finance Association, vol. 49(3), pages 819-49, July.
[Downloadable!] (restricted)
Other versions:
James Dow & Gary Gorton, 1993.
"Arbitrage Chains,"
NBER Working Papers
4314, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
James Dow & Gary Gorton, 1993.
"Arbitrage Chains,"
CEPR Financial Markets Paper
0035, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 53--56 Great Sutton Street, London EC1V 0DG.
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