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Do Noise Traders “Create Their Own Space?”

Published online by Cambridge University Press:  06 April 2009

Ravi Bhushan ,
David P. Brown  and
Antonio S. Mello
Ravi Bhushan
Affiliation:
Southern Methodist University
David P. Brown
Affiliation:
Finance Department, School of Business, Indiana University, Bloomington, IN 47405
Antonio S. Mello
Affiliation:
Finance Department, School of Business, University of Wisconsin-Madison, WI 53706
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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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 32 , Issue 1 , March 1997 , pp. 25 - 45
Copyright
Copyright © School of Business Administration, University of Washington 1997

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