Can Noise Traders Survive Essay example

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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…
Thus, the two empirical examples above show that there is a huge discrepancy between real financial markets and efficient-market hypothesis rational investors assumption. However, how do noise traders survive from rational investors and arbitrageurs?

3. Explanation of noise traders’ survival The DSSW model (De Long et.al., 1990) further explains how noise traders can exist in the long run. The efficient-market hypothesis argues that if asset price diverges from its fair value by noise traders, rational arbitrageurs will trade against them hence push the price back to its fair value. However, it is far from the truth in real financial market. If noise traders are too optimistic about stock and have raised up the price of the stock from its fundamental value, an arbitrageur will bear huge risk selling the stock because noise traders optimistic beliefs will not change for a long time, thus the price will not return, or be pushed up even further by noise traders (De Long et.al., 1990). The risk rational arbitrageurs bears trying to change noise traders’ opinions is named “noise trader risk”. Since rational arbitrageurs are risk-averse, the noise trader risk will limit their willingness to trade against noise traders. De Long et.al (1990) argue that “the arbitrage does not eliminate the effects of noise because noise itself creates risk.” Therefore the noise traders can exist in the long run. De Long et.al (1990) also argue that
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