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THE NOISE TRADER EFFECT IN A WALRASIAN FINANCIAL MARKET

Jukka Ilomäki and Hannu Laurila
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Jukka Ilomäki: Faculty of Management, University of Tampere, Finland
Hannu Laurila: Faculty of Management, University of Tampere, Finland

Advances in Decision Sciences, 2018, vol. 22, issue 1, 405-419

Abstract: We assume rational risk averse informed investors who observe noisy information about the true value of a risky asset, rational risk averse uninformed investors who infer the true value from the price, and noise traders without any inferences. We have a static two period model where all trading happens in the first period. We show that, due to a negative shock caused by a random sentiment of noise traders, uninformed investors follow the noise because their risk increases. If there is a positive sentiment shock, uninformed investors bet against the noise. However, the equilibrium price stays at the fundamental value as long as the aggregate effect of informed investors is larger than that of noise traders. Thus, the risk premium adjusts perfectly in the market. This is consistent with the common finding of dynamic adjustment of the fundamental value with a time-varying risk premium.

Keywords: Risk aversion; informed investors; uninformed investors; sentiment shock; fundamental value (search for similar items in EconPapers)
JEL-codes: G1 G11 G14 G4 (search for similar items in EconPapers)
Date: 2018
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