Behavioral Finance Economics 437

The Great Crash of 2008-09 Oct 2007 14,000 Feb 2013 14,000 March, 2009 6,000

Sustained Rally from 2013-2016 Nov 2016 18,000 Feb 2013 14,000

Since Nov 2016 Election Feb 2018 26,150 This Morning 23,345 Nov 2017 Tax Cut Passes 23,500 Nov 2016 18,000

The Price of the Risky Asset Taken from equation 2.9 on page 37 in Shleifer’s “Inefficient Markets”

The Main Issues What happens in equilbrium Undetermined Some forces make pt > 1, some forces push pt < 1, result is indeterminant Who makes more profit, arbitrageurs or noise traders? Depends But, it is perfectly possible for arbitrageurs to make more! Survival?

When Do Noise Traders Profit More Than Arbitrageurs? Noise traders can earn more than arbitrageurs when ρ* is positive. (Meaning when noise traders are systematically too optimistic) Why? Because they relatively more of the risky asset than the arbitrageurs But, if ρ* is too large, noise traders will not earn more than arbitrageurs The more risk averse everyone is (higher λ in the utility function, the wider the range of values of ρ for which noise traders do better than arbitrageurs

What Does Shleifer Accomplish? Given two assets that are “fundamentally” identical, he shows a logic where the market fails to price them identically Assumes “systematic” noise trader activity Shows conditions that lead to noise traders actually profiting from their noise trading Shows why arbitrageurs could have trouble (even when there is no fundamental risk)

The End