Noise Trader Risk in Financial Markets

This paper builds a simple overlapping-generations model of an asset market with two types of traders – “noise traders,” who hold erroneous, randomly-varying beliefs about an asset’s expected return, and rational “sophisticated investors” who trade against them – to formalize why arbitrage does not fully correct noise traders’ mispricing even though there is no fundamental (dividend) risk at all. Because next period’s noise traders’ beliefs are themselves unpredictable, today’s arbitrageur who bets against the current mispricing bears a risk – “noise trader risk” – that noise traders might become even more extreme before he can liquidate; this risk limits how aggressively sophisticated investors will bet against them, so prices can diverge significantly from fundamental values, and the paper shows that noise traders can earn a higher expected return than sophisticated investors precisely by bearing more of the price risk that their own unpredictable trading creates. The model does not imply that noise traders profit merely for bearing genuine economic risk – “for the economy as a whole, there is no risk to be borne” – and the condition for noise traders to out-earn sophisticated investors (on average bullish, but not too bullish) is narrow, since relative returns are pulled up by a “hold more” effect and a “create space” effect but pulled down by a “price pressure” effect and a “buy high, sell low” effect that dominates at high bullishness. The authors argue the model offers a unified, qualitative account of several asset-pricing anomalies: excess volatility and mean reversion in stock and bond returns, the persistent, fluctuating discount of closed-end fund prices below net asset value, and – more speculatively – the Mehra-Prescott equity premium puzzle, since noise trader risk pushes the risky asset’s average price below fundamental value independently of its covariance with aggregate consumption.

Robert J. Waldmann | Macro Paper Warehouse

Noise Trader Risk in Financial Markets