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Dual decision processes and noise trading

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Abstract

Evidence from nancial markets suggests that asset prices can be consistently far from their funda- mental value. Prices seem to underreact to news in the short-run and overreact in the long-run. In this paper, we use Dual Process Theory to describe traders behavior. In particular, a part of traders holds wrong beliefs anytime the market environment does not change suciently. The proportion of traders with wrong beliefs will depend on how similar past market environments are with the present one. We show that such model not only can be seen as a way of endogenizing noise trading, but also provides a justi cation for noise traders' beliefs and it shows that underreaction and overreaction naturally arise in such framework. Finally, we discuss how the model might help understanding the emergence of the equity-premium puzzle and its variation through time.

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  • Francesco Cerigioni, 2016. "Dual decision processes and noise trading," Economics Working Papers 1553, Department of Economics and Business, Universitat Pompeu Fabra.
    • Handle: RePEc:upf:upfgen:1553
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    More about this item

    Keywords

    Asset Pricing; Dual Processes; Noise Trading; Underreaction; Overreaction; Equity-Premium Puzzle;
    All these keywords.

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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