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Dual decision processes and noise trading

Francesco Cerigioni

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: Evidence from nancial markets suggests that asset prices can be consistently far from their funda- mental value. Prices seem to underreact to news in the short-run and overreact in the long-run. In this paper, we use Dual Process Theory to describe traders behavior. In particular, a part of traders holds wrong beliefs anytime the market environment does not change suciently. The proportion of traders with wrong beliefs will depend on how similar past market environments are with the present one. We show that such model not only can be seen as a way of endogenizing noise trading, but also provides a justi cation for noise traders' beliefs and it shows that underreaction and overreaction naturally arise in such framework. Finally, we discuss how the model might help understanding the emergence of the equity-premium puzzle and its variation through time.

Keywords: Asset Pricing; Dual Processes; Noise Trading; Underreaction; Overreaction; Equity-Premium Puzzle (search for similar items in EconPapers)
JEL-codes: G02 G11 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mst and nep-upt
Date: 2016-09
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