Noise Trader Risk in Financial Markets
Examines how noise traders can limit arbitrage even in an environment that is very close to a textbook model. The author constructs an overlapping generation (OLG) model where noise traders generate unpredictable erroneous beliefs and arbitrageurs try to exploit these misperceptions. He shows that noise traders can affect prices and that they could even earn a higher average rate of return. The model also illustrates that even arbitrage of fundamentally identical securities can be risky, so with lack of close substitutes, it might be riskier still.
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