Lecture 3 Behavioral Finance

Teaching Goals
The Noise Trader Model of DeLong et al. (1990)

Implications of Noise Trader Risk
Noise traders create their own space
Application: Examples of Persistent Mispricings
Behavioral Finance
Lecture 3 - The Limits to Arbitrage
Dr. Markus Demary
Ulm University
Summer Term 2021
Dr. Markus Demary Behavioral Finance

Teaching Goals
1 Teaching Goals
1 The Noise Trader Model of DeLong et al. (1990)

Assumptions
Rational Traders’ Demand
Noise Traders’ Demand
Equilibrium Asset Prices
1 Implications of Noise Trader Risk
1 Noise traders create their own space
1 Application: Examples of Persistent Mispricings

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
The Limits to Arbitrage
Teaching Goals: Students should learn
∙ how irrational traders can limit arbitrage

∙ how irrational traders can stay in the market for a longer time
∙ how irrational traders create their own space
∙ two period overlapping generations model

∙ Two types of traders: sophisticated traders and noise traders interact
∙ noise traders misperceive the fundamental value
Implications of the Model
∙ long-lasting periods of over- and undervaluations

∙ asset prices are excessively volatile (with respect to their fundamental values)
∙ irrationality can stay in the market

Teaching Goals
The Limits to Arbitrage
The influence of trading strategies that aim to exploit mispricings can be limited by:
Fundamental risk
∙ the fundamental value is not constant in time

∙ arbitrageurs have to forecast the future fundamental value
∙ they face fundamental risk due to their forecasting errors
∙ forecasting errors limit the decisions of risk-averse traders
Noise trader risk
∙ noise traders’ demand creates an additional source of risk

∙ risk-averse arbitrageurs decrease their demand for the asset
Implementation costs
∙ arbitrageurs face search costs in finding mispricings

∙ some arbitrage opportunities are unattractive due to transaction costs

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
Assumptions (I)
DeLong et al (1990): ”Noise Trader Risk in Financial Markets”
The noise trader approach rests on two assumptions
1. Some investors are not fully rational
∙ their demand for risky assets is affected by their beliefs and sentiment that are not fully
justified by fundamental news
∙ noise traders tend to overreact/underreact to news
2. Arbitrage is risky
∙ irrational traders introduce an additional source of risk

∙ arbitrage (trading by fully rational, but risk-averse agents) is therefore limited
Implications
∙ changes in investor sentiments are not fully countered by arbitrageurs

∙ therefore these sentiments will affect asset returns even in the longer term

Teaching Goals
Assumptions (II)
Group 1: sophisticated traders
∙ fully rational traders

∙ perceive the fundamental value correctly
∙ take the existence of noise traders into account when forming expectations
∙ return expectation: Rte = E[Rt ]
Group 2: noise traders
∙ irrational traders
∙ react on noise rather than on true information
∙ neglect the existence of sophisticated traders
∙ return expectation: Rte = E[Rt ] + ρt , with ρt ∼ N (ρ∗ , σρ2 )
∙ noise traders estimate is above or below the rational expectations benchmark

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
Rational Traders’ Demand (I)

Two assets exist

∙ risk-less asset: constant price equal to one and constant nominal dividend r
∙ risky asset: constant dividend r, but its price varies over time
∙ there is no fundamental risk, only noise trader risk
Rational Traders’ Utility
U (wt ) = E[wt ] − γV [wt ] (1)
∙ U (.): utility function

∙ wt : the trader’s wealth
∙ E[wt ]: expected wealth
∙ V [wt ]: variance of wealth
∙ γ: Arrow-Pratt measure of risk-aversion

Teaching Goals
Rational Traders’ Demand (II)

Expected wealth
E[wt ] = w0 (1 + r) + λ(r + pet+1 − pt (1 + r)) (2)
∙ λ: number of risky shares

∙ w0 : initial wealth
∙ w0 (1 + r): wealth from investment in risk-free asset
∙ pt (1 + r): amount (1 + r) is used to purchase risky asset at price pt
∙ r + pet+1 : dividend and expected resale price

Teaching Goals
Rational Traders’ Demand (III)

Expected utility
E[U ] = E[λ(r + pet+1 − pt (1 + r)) + w0 (1 + r)] (3)

− γV [λ(r + pet+1 − pt (1 + r)) + w0 (1 + r)] (4)
∂E[U ]
∙ first-order condition: ∂λ
=0
∙ becomes: r + pet+1 − pt (1 + r) − 2γV [pt+1 ] = 0
∙ solution
r + pet+1 − pt (1 + r)
λ= (5)
2γV [pt+1 ]

Teaching Goals
Rational Traders’ Demand (IV)

Maximizing U (wt ) with respect to λ leads to the optimal demand λs of smart

traders
Sophisticated Traders’ demand
r + pet+1 − pt (1 + r)
λs = (6)
2γV [pt+1 ]
Definition: portfolio return Demand for the risky asset
e
Rt+1
e
Rt+1 =r+ pet+1 − pt (1 + r) (7) λs = (8)
2γV [pt+1 ]

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals

Maximizing U (wt ) with respect to λ leads to the optimal demand λn of noise traders
Noise Traders’ demand
n r + ρt + pet+1 − pt (1 + r)
λ = (9)
2γV [pt+1 ]
Portfolio Return
e e
Rt+1 = r + ρt + pt+1 − pt (1 + r) (10)
Noise traders over-/underestimate returns
∙ ρt > 0: noise traders hold a higher share of the risky asset

∙ ρt < 0: noise traders hold a smaller share of the risky asset

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
Equilibrium Asset Prices (I)

Fractions of rational and noise traders

∙ noise traders: µ
∙ rational traders: 1 − µ
Supply equals demand
(1 − µ)λs + µλn = 1 (11)
∙ supply of the risky asset is normalized to 1

∙ (1 − µ)λs : demand of smart traders
∙ µλn : demand of noise traders

Teaching Goals
Equilibrium Asset Prices (II)

Plugging the demand equations in yields
e
Rt+1 R e + ρt
+ µ t+1
(1 − µ) = 1 (12)
2γV [pt+1 ] 2γV [pt+1
r + pet+1 − pt (1 + r) r + pet+1 + ρt − pt (1 + r)
(1 − µ) +µ = 1 (13)
2γV [pt+1 ] 2γV [pt+1 ]
Solving for the equilibrium price yields
r + pet+1 + µρt − 2γV [pt+1 ] = pt (1 + r) (14)

r + pet+1 + µρt − 2γV [pt+1 ]
⇐⇒ pt = (15)
1+r

Teaching Goals
Equilibrium Asset Prices (III)

Rational expectations solution

Price in period t depends on expected price in period t + 1: forward-looking difference equation
Assumption: steady state with pet+1 = pet+2 and V [pt+1 ] = V [pt+2 ]
1 e

pt+1 = r + pt+2 − 2γV [pt+2 ] + µρt+1
1+r
1 e

E[pt+1 ] = E r + pt+2 − 2γV [pt+2 ] + µρt+1
1+r
1
= r + E[pt+2 ] − 2γV [pt+2 ] + µE[ρt+1 ]
1+r
1 ∗

= r + E[pt+1 ] − 2γV [pt+1 ] + µρ
1+r
Rearranging yields
∗
(1 + r)E[pt+1 ] = r + E[pt+1 ] − 2γV [pt+1 ] + µρ
∗
rE[pt+1 ] = r − 2γV [pt+1 ] + µρ
2γV [pt+1 ] µρ∗
E[pt+1 ] = 1− +
r r

Teaching Goals
Equilibrium Asset Prices (IV)

Calculation of the variance
1
e

V [pt+1 ] = V r + pt+2 − 2γV [pt+2 ] + µρt+1
1+r
1
= V µρt+1
1+r
µ 2
= [ρt+1 ]
1+r
µ 2 2
= σρ
1+r

Teaching Goals
Equilibrium Asset Prices (V)

Calculation of the equilibrium price
1 e

pt = r + pt+1 − 2γV [pt+1 ] + µρt (16)
1+r
with
2γV [pt+1 ] µρ∗
E[pt+1 ] = 1 − + (17)
r r
and
µ 2 2
V [pt+1 ] = σρ (18)
1+r

Teaching Goals

1 e

pt = r + pt+1 − 2γV [pt+1 ] + µρt
1+r
1 2γV [pt+1 ] µρ∗
= r+1− + − 2γV [pt+1 ] + µρt
1+r r r
µ
2
1 2γ 1+r σρ2 µρ∗ µ 2 2
= r+1− + − 2γ σρ + µρt
1+r r r 1+r
µ
2
1 2γ 1+r σρ2 µρ∗ µ 2 2
= r+1− + − 2γ σρ + µρt
1+r r r 1+r
(19)

Teaching Goals

µ
2
1 2γ 1+r σρ2 µρ∗ µ 2 2
pt = r+1− + − 2γ σρ + µρt
1+r r r 1+r
µ
2
1 µρ∗ 2γ 1+r σρ2 µ 2 2
= 1+r+ + µρt − − 2γ σρ
1+r r r 1+r
µ
2
1 µρ∗ 2γ 1+r σρ2 µ 2 2
= 1+r+ + µρt − + 2γ σρ
1+r r r 1+r
∗
1 µρ 2γ µ 2 2 2γr µ 2 2
= 1+r+ + µρt − σρ + σρ
1+r r r 1+r r 1+r
∗
1 µρ 2γ(1 + r) µ 2 2
= 1+r+ + µρt − σρ
1+r r r 1+r

Teaching Goals
Equilibrium Asset Prices (VI)

1 µρ∗ 2γ(1 + r) µ 2 2
pt = 1+r+ + µρt − σρ
1+r r r 1+r
∗
1 µρ ∗ ∗ 2γ(1 + r) µ 2 2
= 1+r+ + µρt + µρ − µρ ρt − σρ
1+r r r 1+r
1 µρ∗ ∗r ∗ 2γ(1 + r) µ 2 2
= 1+r+ + µρ + µ(ρt − ρ ) − σρ
1+r r r r 1+r
1 (1 + r)µρ∗ ∗ 2γ(1 + r) µ 2 2

= 1+r+ + µ(ρt − ρ ) − σρ
1+r r r 1+r
µρ∗ µ(ρt − ρ∗ ) 2γ µ 2 2
= 1+ + − σρ (20)
r 1+r r 1+r

Teaching Goals
Equilibrium Asset Prices (VII)

Rational expectations solution

Since pet+1 is rational, we can solve it as a forward-looking difference equation
The asset price consists of four parts
µρ∗ µ(ρt − ρ∗ ) 2γ µ 2 2
pt = 1+ + − σρ (21)
r 1+r r 1+r
1. 1: fundamental value for risk-neutral investors

µρ∗
2. r : long-term influence of noise traders
3. µ(ρt − ρ∗ )/(1 + r): short-term influence of noise traders
2γ µ
2
4. r 1+r σρ2 : discounted risk-premium, compensation for noise-trader risk
−→ the only source of price variability is noise trader risk (since we abstract from fundamental
risk)
−→ since σρ2 > 0 we observe excess volatility

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
Implications of Noise Trader Risk (I)

1. No noise traders: µ = 0
pt = 1 (22)
∙ asset price equals its arbitrage-free fundamental value
2. Noise traders have correct long-run views ρ∗ = 0
µρt 2γµ2 σρ2

pt = 1 + − (23)
(1 + r) r(1 + r)2
∙ asset is traded at a discount, since noise traders still create risks through
periods of bullish and bearish moods

Teaching Goals
Implications of Noise Trader Risk (II)

3. Noise traders are bearish on average ρ∗ < 0
µ(ρt − ρ∗ ) µρ∗ 2γµ2 σρ2

pt = 1 + + − (24)
1+r r r(1 + r)2
∙ they earn lower returns on average

∙ hence, they will be crowded out in the long-run
4. Noise traders are bullish on average ρ∗ > 0
µ(ρt − ρ∗ ) µρ∗ 2γµ2 σρ2

pt = 1 + + − (25)
1+r r r(1 + r)2
∙ µ > µ∗ : noise traders realize higher average profits

∙ µ < µ∗ : smart investors realize higher average profits

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
Noise traders create their own space (I)
Milton Friedman’s (1953) argument against irrational traders
∙ irrational investors should lose money on average

∙ their strategies should therefore vanish over time
DeLong et al. (1990) argue
∙ irrational traders can impact asset prices and this impact cannot be
arbitraged away
∙ arbitrage can be risky, risk-averse arbitrageurs lower their demand
∙ hence, mispricings can exist for a long time

Teaching Goals
Noise traders create their own space (II)
Return differential between noise traders and rational investors
∙ return differential
n s e
∆R = (λ − λ )(r + pt+1 − pt (1 + r)) (26)
∙ the difference in share demand is
n s r + pet+1 − pt (1 + r) + ρt r + pet+1 − pt (1 + r)+
λ −λ = − (27)
2γV [pt+1 ] 2γV [pt+1 ]
ρt ρt
= = 2 (28)
2γV [pt+1 ] 2γ µ
σρ2
1+r
∙ λn > λs when ρt > 0: when noise traders overprice the risky asset, they hold more
quantities of the risky asset

Teaching Goals
Noise traders create their own space (III)
Excess returns
e e 1 e

r + pt+1 − pt (1 + r) = r + pt+1 − r + pt+1 − 2γV [pt+1 ] + µρt (1 + (29)
r)
1+r
e e
= r + pt+1 − r − pt+1 + 2γV [pt+1 − µρt (30)
= 2γV [pt+1 − µρt (31)
µ 2 2
= 2γ σρ − µρt (32)
1+r
∙ excess returns increase in the variance of the mispricing σρ2 , but decrease in the overpricing
itself ρt
∙ higher variance in the mispricing leads to a higher variance in noise traders’ demand for the
risky asset which leads to higher price volatility
∙ for the market to clear, the risky asset must trade at a discount which raises its expected
return
∙ overpricing pushes up noise traders demand, which increases the price and lowers the return

Teaching Goals
Noise traders create their own space (IV)
Difference in expected returns
n s e ρt µ 2 2
(λ − λ )(r + pt+1 − pt (1 + r)) = 2 2γ σρ − µρt (33)
2γ µ
σr2 ho 1+r
1+r
(ρt )2
= ρt − µ 2
(34)
2γ (1+r)2σ ρ
Because E[ρ2t ] = V [ρt ] + (E[ρt ])2 = σρ2 + (ρ∗ )2 , we arrive at
E[(ρt )2 ] ∗
σρ2 + (ρ∗ )2
E[ρt ] − µ = ρ − µ (35)
2γ (1+r)2 σ 2 ρ 2γ (1+r)2σ ρ
2
Noise trader will have higher excess returns if

∙ they overprice the risky asset in the long-term ρ∗ > 0
(ρ∗ )2
∙ they do not overprice so much that the asset price gets too high − µ
2γ σ2 ρ
(1+r)2
∙ if they achieve a large variance in mispricing. This will discourage rational traders from
buying the asset, it drives the price of the risky asset down and raises its expected return

Teaching Goals
Noise traders create their own space (V)
1. Noise traders a bearish (ρ∗ < 0)
∙ noise traders underestimate returns

∙ expected return differential is negative
∙ noise traders earn lower average returns compared to rational investors
∙ noise traders will be crowded out, since they lose money
2. Noise traders a bullish (ρ∗ > 0)
∙ noise traders overestimate returns

∙ µ < µ∗ : noise traders should vanish since they are a minority over smart investors
∙ µ > µ∗ : smart investors earn lower average returns compared to noise traders
∙ under ρ∗ > 0 and µ > µ∗ noise traders survive in the long-run and influence asset prices

Teaching Goals
Noise traders create their own space (VI)
Noise traders create market risk
∙ risky asset trades at a discount p < pf = 1

∙ if this dscount is not overcompensated by the bullishness of noise traders ρ∗ > 0
−→ investment in the risky asset yields a higher return than investment in the riskless asset
r
p > r if pt < 1
t
Noise traders will hold more risky assets
∙ therefore they will earn higher returns on average

∙ risk-averse arbitrageurs will build no counterpositions against the irrational excess demand
∙ noise traders profits will not be arbitraged away
∙ noise traders create their own space by creating market risk
Noise trader model with fundamental risk
∙ arbitrage will be risky due to uncertain dividends

∙ a stable equilibrium with a survival of noise traders and rational investors exists

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
1 Teaching Goals

Assumptions

Teaching Goals
Examples of Persistent Mispricings (I)

Barberis and Thaler (2003, pp. 1059-1062)
Twin Shares
∙ in 1907 Royal Dutch and Shell agreed to merge in al 60:40 basis while
remaining separate entities
∙ Royal Durch share is a claim of 60 percent of the total cash flow
∙ Shell share is a claim of 40 percent of the total cash flow
∙ fundamental value: price of Royal Dutch should be 1.5 times the market
value of Shell
∙ empirically:
∙ strong deviations from 1.5
∙ Royal Dutch is sometimes 35 percent underpriced and sometimes 15 percent
overpriced

Teaching Goals
Examples of Persistent Mispricings (II)

Barberis and Thaler (2003, pp. 1059-1062)
Index Exclusions
∙ every few weeks a stock is removed from S&P500 and a new stock is
included
∙ index should be representative for the US economy, no information about
the riskyness of a firm
∙ in an efficient market such an inclusion should not lead to a price change
since fundamental values stay the same
∙ empirically:
∙ average price jump after inclusion is 3.5 percent
∙ after Yahoo was added it price jumped by 24 percent within one day

Lecture 3 Behavioral Finance

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Teaching Goals

The Noise Trader Model of DeLong et al. (1990)

Lecture 3 - The Limits to Arbitrage

Dr. Markus Demary

Summer Term 2021

Dr. Markus Demary Behavioral Finance

1 The Noise Trader Model of DeLong et al. (1990)

1 Implications of Noise Trader Risk

1 Noise traders create their own space

1 Application: Examples of Persistent Mispricings

Dr. Markus Demary Behavioral Finance

1 The Noise Trader Model of DeLong et al. (1990)

1 Implications of Noise Trader Risk

1 Noise traders create their own space

1 Application: Examples of Persistent Mispricings

Dr. Markus Demary Behavioral Finance

The Limits to Arbitrage

Teaching Goals: Students should learn

∙ how irrational traders can limit arbitrage

The Noise Trader Model of DeLong et al. (1990)

∙ two period overlapping generations model

Implications of the Model

∙ long-lasting periods of over- and undervaluations

Dr. Markus Demary Behavioral Finance

The Limits to Arbitrage

∙ the fundamental value is not constant in time

Noise trader risk

∙ noise traders’ demand creates an additional source of risk

∙ arbitrageurs face search costs in ﬁnding mispricings

Dr. Markus Demary Behavioral Finance

1 The Noise Trader Model of DeLong et al. (1990)

1 Implications of Noise Trader Risk

1 Noise traders create their own space

1 Application: Examples of Persistent Mispricings

Dr. Markus Demary Behavioral Finance

1 The Noise Trader Model of DeLong et al. (1990)

1 Implications of Noise Trader Risk

1 Noise traders create their own space

1 Application: Examples of Persistent Mispricings

Dr. Markus Demary Behavioral Finance

1 The Noise Trader Model of DeLong et al. (1990)

1 Implications of Noise Trader Risk

1 Noise traders create their own space

1 Application: Examples of Persistent Mispricings

Dr. Markus Demary Behavioral Finance

The noise trader approach rests on two assumptions

1. Some investors are not fully rational

∙ irrational traders introduce an additional source of risk

∙ changes in investor sentiments are not fully countered by arbitrageurs

Dr. Markus Demary Behavioral Finance

Group 1: sophisticated traders

∙ fully rational traders

Group 2: noise traders

Dr. Markus Demary Behavioral Finance

1 The Noise Trader Model of DeLong et al. (1990)

1 Implications of Noise Trader Risk

1 Noise traders create their own space

1 Application: Examples of Persistent Mispricings

Dr. Markus Demary Behavioral Finance

1 The Noise Trader Model of DeLong et al. (1990)

1 Implications of Noise Trader Risk

1 Noise traders create their own space

1 Application: Examples of Persistent Mispricings