Iycee Charles de Gaulle Summary Noise Traders vs. Efficient Markets Essay

Noise Traders vs. Efficient Markets Essay

ABSTRACT

Presented below is a simple model of the market of assets in which case, noise traders who are irrational with stochastic beliefs which are erroneous both influence prices as well as earning more expected revenues. The uncertainty of the beliefs of the noise traders presents a risky situation in the asset prices that stops traders from enthusiastically betting in the opposite direction from them. The implication is that prices have the potential of changing in a significant manner from the principle values even in a situation where fundamental risk is unavailable.   In addition, possessing an unpropotionate level of risk that they create all alone give room to the noise traders to acquire more expected returns as opposed to the investors who are rational. The paper draws a contrast between noise traders and the efficient market hypothesis as regards the issue of pricing in financial markets.

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Introduction

            Efficient Market is the type of market where the securities in prices reflect information. There exists two types of investors within the market which include the rational speculators who first look for information before trading (Eleswarapu, and Reinganum, 1993). The other type are the noise traders who more so trade on the basis of imperfect information. This makes them cause the prices in the market to deviate from their equilibrium values (Einhorn, 1976). The rational speculators on the other hand srive to stabilize the prices out of the good information they obtain. It has been found that the assumption made that rational speculators eliminate the shifts in prices under the efficient market is unrealistic (Schleifer and Summers, 1986, p. 23).

Noise Traders and Efficient Markets approaches to pricing in the Financial markets:Comparison

            Both the information provided by either the efficient markets or the noise traders can sometimes lead to permanent price rise. [1]Huberman and Regev  provide an example of how and not when information is released can cause stock prices reactions. Efficient markets and the noise traders have on some occasions failed to correct individual biases in the market concerning the price differences among similar consumer products. This is very evident in the transition from micro behavior to macro behavior (Pratt, Wise and Zecknauster, 1979).

            In both the cases it is seen that security in prices adjusts to the new information within a short time of the event announcement.

 [2]Though the evidence regarding existence of efficient markets may seem considerable, there is indeed no acceptable implication of marketing terms. The noise traders sometimes demand more of the risky assets whenever they overestimate expected returns unlike the efficient market which demand less whenever they underestimate the expected return (Huber man and Regev 2001).

            Both noise traders and efficient markets limit their demand for asset (u) since they commonly predict that the prices which they sell the assets when old are dependent on uncertain beliefs of the next generational traders. This affects all investors in the financial markets hence limits on the extent to which they compete against one another (De Long, et al, 1989. p.9)

Contrast

             In the efficient markets the securities in prices is set based on information as opposed to the Noise traders where prices are reflected based on imperfect information. This causes big deviations of prices from their equilibrium values (Bernard, 1993). The efficient markets on the other hand play very crucial role in the stabilizing of market prices.

Most of the strategies from the noise traders are made guided by noise rather than the evaluation of information (Eberhart, and Sweeney, 1992). This does not apply to the financial market because prices responds only to fundamental news and not to investor demands. The efficient market support is provided by professional financial analysts who help in predicting both the changes in fundamentals and also provide possible changes that might occur in the sentiments of other investors. This makes it possible to track indicators of market demand (Shleifer and Summers, 1986, p. 26).

            The noise traders sometimes play important roles in promoting transactions and this may lead to great influence in prices (Basu,1977). This is so because people tend to believe that explanations rooted in human and social psychology helps in advancing the peoples understanding of stock market behavior. However the studies based on the efficient markets have proved to make invaluable contribution to the understanding of the securities in the financial market. The market hence responds to the new information it is provided with, but information is not the only variable affecting security of price valuation.(Russel and Torbey, 2002).

            It is also observed that financial equilibrium models based on efficient market hypothesis have failed to depict trading operations, hence calling for the development of a more coherent theory of stock market behavior (Ball, and Brown 1968). The prices have been set based on random walk model and the predictable variations, if any of these is found to be statistically insignificant (Fama,1970). The noise traders base their portfolios on incorrect beliefs by clinging on to the pseudo signals from technical analysts or economic consultants. This hence creates some belief in them that they have special information concerning future prices of assets (De Long, et al, 1989. p.5).

Efficient Market Hypothesis to Pricing

            It would be quite difficult to talk about efficient market approaches to pricing in financial markets without discussing the concept of efficient market hypothesis. At the same time, the concept of efficient financial market efficiency is discussed (Elroy & Massoud, 2001). Well, a financial market normally is a place where capital and credit are exchanged. Financial market is made up of the money market as well as the capital market (Annuar & Shamsher, 1993).  Money market is the place where short-term debt securities are traded. The money market usually is a safe besides the fact that it has very high liquidity. Capital market on the other hand is the market for long-term debts (Fama, 1970).

            An efficiency market implies a situation in which the prevailing prices give an indication of all the information available to the public about a security (Jonathan et al, 2001). The fundamental issue underlying the concept of market efficiency is the fact that competition will be the major driver of all information relating to price very fast. The implication is that the highest price that an investor is willing to pay to acquire a financial asset is in real sense the prevailing value of projected cash payments (Richard, 1999). These are usually discounted at a rate which is higher in order to compensate the investor owing to the unpredictability associated with the projections of the cash flows (Bernama, 2001).

            According to Mark et al, (2000), what is meant is that investors are usually involved in exchanging information as a good in the financial market for the future projected cash flows as well as the information concerning the prices quickly.[3]   It is important to note that the theory of efficient market hypothesis (EMH) has widely been accepted as one of the fundamental principles of modern day financial pricing (Kok, 1995). A financial market would be considered as efficient in a case where the response of market prices to new information is not only immediate but also without any biases (Tan, 2001). EMH propagates the notion that market information is incorporated into the prices pf an asset not only on an immediate basis but also in an efficient manner at any time. The implication here would be that past market information would not be used to forecast future price trends (Yong, 1994).

            Three forms of EMH are available. The first is the weal form EMH which states that prevailing prices of assets already indicate historical prices and volume of information. The second model the semis strong EMH states that all the available public information has already been captured in the prices of the asset (Jonathan et al, 2001). The last model, the strong form EMH states that insider information as well is quickly factored in by the selling prices and thus could never used to obtain above normal trading proceeds. The implication therefore is that all the information be it public or insider, is totally incorporated in the prevailing price of a security (Tan, 2001).

            The efficient market hypothesis takes a position that financial assets need to sell their principle values. In many instances, however, measuring the fundamental value of an asset is usually very difficult thus implying that it would be difficult to achieve the above feat (Bollerslev& Hodrick, 1990).  However the principle value of funds which is closed ended is capable of being determined. This is more so given the fact that the funds give out dividends which equate the summation of the dividends which the stock in its portfolio pays. The implication here is that market price for the portfolio of that fund should be the market price (Tan, 2001).

Conclusion

            In spite of this however, have always been selling at significantly fluctuating discount levels which have comparatively been small in the occasions of bulk markets (Takatoshi, 1990). Attempts to provide an explanation to the above have not been satisfactory since two available explanations hinge on the concept of agency in the management of funds (Bollerslev& Hodrick, 1990).  The other principle is the wrong calculation of the net value of the asset more so with regards to the failure to factor out the tax liability of the capital gains of the fund.[4] It implies therefore that the explanation form the agency concept is not consistent with the fact that funds with higher costs of transaction as well as stock turnover usually are not sold at higher discounts (De Long et al, 1989).

            It has been shown that risk given rise to by the uncertainty of opinions of the investor’s lowers how attractive arbitrage is (Lakonishok, & Shleif, 1993).   So long as the arbitrageurs have short financial plans, thus must be worries about offering for liquidation their financial investments, their ambition will be impeded even if risk is absent (Chevalier, 1996). In such a situation therefore, noise trading has the potential of leading to a large variation between the market prices and the fundamental values (De Long et al, 1989).

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[1] The authors noted that these results do not describe other markets
[2] Note that the Ball and Brown (1968) study is an association study. Event studies measure the price impact of an information event in a short window, contrary to association studies which base its measurement of important information to stock price adjustments.
[3] An efficient market comes about when fresh information is factored into the pricing such the issue of pricing is considered as information. This would mean that the prevailing market prices will be a reflection of all the present information. In such situations, the prevailing market price in a given financial market would represent the most accurate and un-biased financial worth of the given investment.

of all the present information. In such situations, the prevailing market price in a given financial market would represent the most accurate and un-biased financial worth of the given investment.
[4] The agency theory with regards to discounts is not in a position to provide an explanation to how the closed end funds are usually come with.