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Behavioral Finance

Behavioral Finance. Economics 437. Black on “Noise”. Black strong believer in noise and noise traders in particular They lose money according to him (though they may make money for a short while) Prices are “efficient” if they are within a factor of 2 of “correct” value

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Behavioral Finance

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  1. Behavioral Finance Economics 437

  2. Black on “Noise” • Black strong believer in noise and noise traders in particular • They lose money according to him (though they may make money for a short while) • Prices are “efficient” if they are within a factor of 2 of “correct” value • Actual prices should have higher volatility than values because of noise

  3. What is a short sale? • Sell 100 shares of GOOG at 580 • What happens? • You enter an order to sell 100 shares at 580 • The order is “executed” – meaning that you have sold 100 shares to someone else somewhere • Mechanically, how do provide the 100 shares to the buyer? • You borrow the 100 shares from an institutional holder (like UVA’s Endowment) • You provide collateral equal to the value of the stock ($ 58,000) and perhaps a little more collateral in case the stock price goes up. • You mark to market • If stock goes to 585, you send $ 500 more in cash to lender • If stock goes to 575, lender sends you $ 500 in cash • Where do you get the $ 58,000? The buyer gives you $ 58,000 and you pass that through to the stock lender • On some future date, you buy 100 shares at say 550, paying $ 55,000 which you receive back from the stock lender when you return the 100 shares to the lender

  4. Short Sale Mechanics 100 shares of GOOG at 580 Stock buyer Short seller 100 shares $ 58,000 UVA Endowment Short seller 100 shares $ 58,000

  5. Overlapping Generations Structure • All agents live two periods • Born in period 1 and buy a portfolio (s, u) • Live (and die) in period 2 and consume • At time t • The (t-1) generation is in period 2 of their life • The (t) generation is in period 1 of their life • So, they “overlap” t1 t2 t3 t4

  6. How many are arbitrageurs? How many are noise traders? 0 1 The total number of traders are the same as the number of real numbers Between zero and one (an infinite number) The term “measure” means the size of any interval. For example the “measure” of the interval between 0 and ½ is ½. Interestingly, the measure of a single point (a single number) is zero. The measure of the entire interval between zero and one is 1. You can think of it as a fraction of the entire interval. The measure of noise traders is µ and the measure of arbitrage traders is 1 - µ. That is, the fraction of noise traders is µ and everybody else is an arbitrage traders

  7. What is a noise trader? Pt+1 is the price of the risky asset at time t+1 ρt+1 is the “mean misperception” of pt+1 Ρt+1

  8. What is an “arbitrage trader” • Arbitrage traders “correctly” perceive the true distribution of pt+1. There is “systematic” error in estimation of future price, pt+1 • But, arbitrageurs face risk unrelated to the “true” distribution of pt+1 • If there were no “noise traders,” then there would be no variance in the price of the risky asset…..but, there are noise traders, hence the risky asset is a risky asset

  9. Arbitrageurs expectations are “correct;” noise traders expectations are “biased” Difference is ρt+1 Correct mean of pt+1

  10. The Main Issues • What happens in equilbrium • Undetermined • Some forces make pt > 1, some forces push pt < 1, result is indeterminant • Who makes more profit, arbitrageurs or noise traders? • Depends • But, it is perfectly possible for arbitrageurs to make more! • Survival?

  11. When Do Noise Traders Profit More Than Arbitrageurs? • Noise traders can earn more than arbitrageurs when ρ* is positive. (Meaning when noise traders are systematically too optimistic) • Why? • Because they relatively more of the risky asset than the arbitrageurs • But, if ρ* is too large, noise traders will not earn more than arbitrageurs • The more risk averse everyone is (higher λ in the utility function, the wider the range of values of ρ for which noise traders do better than arbitrageurs

  12. The Price of the Risky Asset

  13. What Does Shleifer Accomplish? • Given two assets that are “fundamentally” identical, he shows a logic where the market fails to price them identically • Assumes “systematic” noise trader activity • Shows conditions that lead to noise traders actually profiting from their noise trading • Shows why arbitrageurs could have trouble (even when there is no fundamental risk)

  14. Feedback Models • Central idea is that a price higher than efficient price might have “real” effects. What are they? • Hirshleifer Etal is one example of several attempts to show feedback effects

  15. Hirshleifer, Etal on Feedback • Three dates • Eight kinds of investors • Early and late • Informed and uninformed • Rational and irrational • Mainly rational and irrational (noise) traders • One firm with equity shares • Trades at period 1 and period 2 • Payoff in period 3

  16. Hirshleifer Payoff Function In period 3, payoff is: F = θ + ε + δ εreally plays no role, so lets simplify to: F = θ + δ δ depends upon workers investment in the firm

  17. So what happens in Hirshleifer Etal • Early irrational, but informed, traders benefit because later irrational traders buy and the early traders “know it” • Sometimes early informed traders benefit as well • Late irrational traders get smashed

  18. The End

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