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Do Noise Traders “Create Their Own Space?”

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  • Bhushan, Ravi
  • Brown, David P.
  • Mello, Antonio S.

Abstract

We analyze myopic trader models of noisy prices in financial markets. Unlike extant analysis, such as De Long et al. (1990a), a classical equilibrium exists in our analysis, e.g., a riskless perpetuity is priced by arbitrage and its price does not vary with noise. A unique noisy equilibrium exists only when i) noise traders' beliefs are rational regarding volatility and irrational regarding expected returns, and ii) noise traders can hold infinite positions. In the absence of these strong assumptions, multiple noisy equilibria can coexist with the classical equilibrium, but these equilibria exhibit conflicting comparative statics. Furthermore, the price of a long-lived asset with risky cash flows can vary with noise even when investors are not myopic. One conclusion is that myopia is neither a necessary nor a sufficient condition for noisy prices. A second is that it is difficult, if not impossible, to use myopic trader models to derive implications for investment or regulatory policy.

Suggested Citation

  • Bhushan, Ravi & Brown, David P. & Mello, Antonio S., 1997. "Do Noise Traders “Create Their Own Space?”," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(01), pages 25-45, March.
  • Handle: RePEc:cup:jfinqa:v:32:y:1997:i:01:p:25-45_00
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    Cited by:

    1. Matthew Spiegel, 1998. "Closed-End Fund Discounts in a Rational Agent Economy," Yale School of Management Working Papers ysm80, Yale School of Management, revised 01 Aug 2000.
    2. Craig W. Holden & Avanidhar Subrahmanyam, 2002. "News Events, Information Acquisition, and Serial Correlation," The Journal of Business, University of Chicago Press, vol. 75(1), pages 1-32, January.
    3. Lee, Wayne Y. & Jiang, Christine X. & Indro, Daniel C., 2002. "Stock market volatility, excess returns, and the role of investor sentiment," Journal of Banking & Finance, Elsevier, vol. 26(12), pages 2277-2299.
    4. Matthew Spiegel, 1997. "Closed-End Fund Discounts in a Rational Agent Economy," Finance 9712002, EconWPA.
    5. Masahiro Watanabe, 2002. "Price Volatility and Investor Behavior in an Overlapping Generations Model with Information Asymmetry," Yale School of Management Working Papers amz2636, Yale School of Management, revised 01 Jul 2002.

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