1. Behavioral Finance
Economics 437

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

3. Sustained Rally from
Nov ,000
Feb 2013
14,000

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

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

6. 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?

7. 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

8. 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)

9. The End