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Behavioral Finance

Chapter 2 delves into the assets, players, and behaviors shaping market equilibrium and profitability. The "Paris Problem" highlights intergenerational asset dynamics. Issues like profitability variance, noise trader advantage, and systematic biases are explored, revealing market inefficiencies. Shleifer's work illustrates how noise traders can exploit market inefficiencies, impacting asset pricing.

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Behavioral Finance

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  1. Behavioral Finance Economics 437

  2. Decifering Shleifer Chapter 2 • The assets • The players • Their behavior • Equilibrium • Profitability of the players

  3. The “Paris” Problem • Joey Paris pointed out in class that, as the Shleifer argument reads, there seems to be no reason why “older” agents will sell their risky assets to “younger” agents. They will simply consume them. Hence, risky assets will disappear. • Resolving this requires the assumption that “younger” agents receive an “endowment” that consists, in part, of some of either the consumption good or the riskless asset (which are equivalent) at the beginning of their lives.

  4. 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?

  5. The Key Pricing Equation

  6. 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

  7. 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)

  8. The End

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