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Endogenous Noise Traders

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    We construct a parsimonious model of a financial market where the marginal investor is an endogenous noise trader. Such a trader anticipates that future shocks may force him to exit his position. In compensation he requires a higher return. We show that the original seller of the asset pays the required return. This can only be optimal if the seller has access to an investment opportunity that gives a sufficiently high return, compared to the noise trader's investment opportunities. We also show that, if the noise trader expects to get informative signals, the required return does not necessarily decrease, as claimed in the earlier literature.

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    File URL: http://swopec.hhs.se/hastef/papers/hastef0644.pdf
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    Paper provided by Stockholm School of Economics in its series SSE/EFI Working Paper Series in Economics and Finance with number 644.

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    Length: 14 pages
    Date of creation: 05 Dec 2006
    Date of revision:
    Handle: RePEc:hhs:hastef:0644
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    1. Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
    2. Andrei Shleifer & Robert W. Vishny, 1995. "The Limits of Arbitrage," NBER Working Papers 5167, National Bureau of Economic Research, Inc.
    3. 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.
    4. Markus K. Brunnermeier & Lasse Heje Pedersen, 2005. "Predatory Trading," Journal of Finance, American Finance Association, vol. 60(4), pages 1825-1863, 08.
    5. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March.
    6. S. Baranzoni & P. Bianchi & L. Lambertini, 2000. "Market Structure," Working Papers 368, Dipartimento Scienze Economiche, Universita' di Bologna.
    7. Biais, Bruno & Glosten, Larry & Spatt, Chester, 2005. "Market microstructure: A survey of microfoundations, empirical results, and policy implications," Journal of Financial Markets, Elsevier, vol. 8(2), pages 217-264, May.
    8. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    9. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, number 9780198296980, March.
    10. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September.
    11. Shleifer, Andrei & Summers, Lawrence H, 1990. "The Noise Trader Approach to Finance," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 19-33, Spring.
    12. Madhavan, Ananth, 2000. "Market microstructure: A survey," Journal of Financial Markets, Elsevier, vol. 3(3), pages 205-258, August.
    13. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
    14. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
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