Behavioral Finance - Limits to arbitrage; noise trader risk
6 important questions on Behavioral Finance - Limits to arbitrage; noise trader risk
What is the price pressure effect (1+r)^2(p*)^2?
What is the Friedman effect (1+r)^2sigma_rho^2
What is the create space effect (2lambda)musigma_rho^2?
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How can noise traders have a higher return than sophisticated traders?
- Utility of sophisticated traders by definition higher than utility of noise traders
- Demand for unsafe asset derived from utility maximization, misperception creates bias
- Extra return does not compensate for extra risk for noise traders -> lower utility
So the return of noise traders can be higher, but the risk that they are taking is proportionally even higher
What do noise trader create?
- Excess volatility; market prices move too much relative to their fundamental prices
- Mean reversion; they can push the price in the short term, but in the long-term the price will mean revert
Waht do noise trader NOT create?
- Momentum; their misperception is completely random so they do not create momentum!
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