Title
THE NOISE TRADER EFFECT IN A WALRASIAN FINANCIAL MARKET
Authors
Abstract
We assume rational risk averse informed investors who observe noisy information about the truevalue of a risky asset, rational risk averse uninformed investors who infer the true value from the
price, and noise traders without any inferences. We have a static two period model where all trading
happens in the first period. We show that, due to a negative shock caused by a random sentiment of
noise traders, uninformed investors follow the noise because their risk increases. If there is a positive
sentiment shock, uninformed investors bet against the noise. However, the equilibrium price stays at
the fundamental value as long as the aggregate effect of informed investors is larger than that of noise
traders. Thus, the risk premium adjusts perfectly in the market. This is consistent with the common
finding of dynamic adjustment of the fundamental value with a time-varying risk premium.
Keywords
Risk aversion, informed investors, uninformed investors, sentiment shock, fundamental value
Classification-JEL
G1, G11, G14, G4
Pages
405-419