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Behavioral Finance Economics 437 – Spring 2009 Professor Burton

Behavioral Finance Economics 437 – Spring 2009 Professor Burton. March 2008 January 2009. Significance of Shleifer Etal Article.

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Behavioral Finance Economics 437 – Spring 2009 Professor Burton

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  1. Behavioral FinanceEconomics 437 – Spring 2009Professor Burton March 2008 January 2009 January 27, 2009

  2. Significance of Shleifer Etal Article • Two assets were identical according to finance theory: both had certain dividend, r each period • One asset fungible into consumption good; that fixes the prices at 1 (using the consumption good as the money unit) • Noise trader is same as arbitrage trader except he is too optimistic (pessimistic) randomly about the future price of the risky asset January 27, 2009

  3. So, what has Shleifer captured • Noise traders can make more money than arbitrageurs • Limits to arbitrage: arbitrageurs worried that overpricing (underpricing might get worse) • No fundamental difference between the assets January 27, 2009

  4. Abreu – BrunnermeierBubbles and CrashesEconometrica, 2003 • What happens when a price starts growing faster than the “correct” price? Actual price Correct price time January 27, 2009

  5. What Happens in Abreu-Brunnermeier? • Price diverges from “correct” price (no one knows why) • Then, sequentially, arbitrageurs gradually realize the price is above the “correct” price • But they keep buying (because others don’t know yet) • Only when a fraction, κ, of all traders realize the price is wrong does the bubble burst. January 27, 2009

  6. Why would the smart guys buy stock when they know it is overpriced? • Because they might be money managers who are compared to the averages. • They might rationally anticipate the “greater fool” who hasn’t yet figured out what they know. January 27, 2009

  7. The End January 27, 2009

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