Can Noise Traders Survive Essay

1851 WordsNov 24, 20128 Pages
Discuss the implications of the paradox that although financial theory assumes that investors are rational in practive, few if any investors appear to approach investments decisions in a rational manner. Can Noise Traders Survive? 1. Introduction Noise Trader is a financial term introduced by Kyle (1985) and Black (1986). It refers to a stock trader who lacks access to inside information and makes irrational investment decisions (De Long et al., 1990). Traditional financial theories are often based on the assumption that all the investors are rational. The burgeoning behavioral finance departs from classical financial theory by dropping this basic assumption (Carty, 2005). In recent years, there has been a growing interest in…show more content…
From the perspective of rational arbitrageurs, if noise traders are all eventually driven out of markets, there will be no price discrepancies for arbitrage. Thus the rational arbitrageurs will also disappear from the markets. In that case, how can the markets maintain a non-arbitrage equilibrium? From the perspective of noise traders, if noise traders are all driven out of markets, how do the markets generate the original noise traders? It seems clear that those two paradoxes serve as evidence of the existence of noise traders. Efficient-market hypothesis also states that it is impossible for investors to consistently out-perform the average market returns, or in other words, “beat the market”, because the market price is generally equal to or close to the fair value (Fama, 1965). It is impossible, therefore, for investors to earn higher returns through purchasing undervalued stocks. Investors can only increase their profits by trading riskier stocks (http://www.investopedia.com/). However, empirically speaking, there is a large quantity of real financial examples to support that stocks are not always traded at their fair value. On Monday October 19, 1987, the financial markets around the world fell by over 20%, shedding a huge value in a single day (Ahsan, 2012). It serves as example that market price can diverge significantly from its fair value. In addition, Warren Buffett has

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