Noise Trading and Contagion

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Contents
Abstract2
Introduction3
Section I: Noise Trading and Contagion Defined4
A Theoretical Analysis of the Concepts of Noise Trading4
A Theoretical Analysis of Contagion and its Relationship with Noise Trading6
Section II: Consolidating Noise Trading with the Concept of an Efficient Market12
The Efficient Market Hypothesis Explained.12
Noise Traders and Information Traders13
The Efficiency Conundrum14
The Consolidation Summarised15
Section III: Market Anomalies; Explained by Noise Trading16
The Model16
Bubbles17
Volatility And Mean Revision In Asset Prices18
Closed-End Mutual Funds19
The Mehra-Prescott Equity Premium Puzzle20
Section IV: Review of the Empirical Performance of Noise Trading20
Conclusion25
References27

Abstract
Irrational uninformed noise traders with fixed beliefs have the ability to influence prices and returns of financial assets. The randomness of noise traders’ beliefs in the financial market creates additional risk which distorts rational arbitrageurs from betting against them. Consequently prices tend to diverge from their fundamental value and numerous anomalies are caused. Correlated liquidity and informational flows pose as channels between countries for contagion to occur. Most of the contagious price response in a given country, from cross-market rebalancing of portfolios from other countries, results in noise trading. Essentially noise traders provide an indispensable component of the markets underlying foundation because they induce sophisticated traders to take market positions that cause the accepted form of the Efficient Market Hypothesis to hold, thus reconciling noise trading with the established definition of an efficient market.

Introduction
This seminar paper aims to explain the concepts of noise trading and contagion, and further elucidate the relationship shared between them. In addition, this paper aims to highlight key empirical findings of noise trading, explain how it can be reconciled in an efficient market and finally, how it accounts for specific anomalies. These topics will be discussed in five separate sections. Section I refers to a theoretical analyses of noise trading, contagion and their relationship, Section II refers to noise trading and its reconciliation with an efficient market, Section III discusses how noise trading can explain certain market anomalies and lastly Section IV reviews the performance of noise trading through empirical evidence. To begin, Section I discusses the effect noise trading has on an efficient market, and the consequential effect on other market participants. Furthermore, the implications that noise traders risk possess on arbitrageurs, and the misrepresentation of returns and prices on market securities will be examined. This section then proceeds to explain, from a theoretical perspective, the concept of contagion and the various causes of this phenomenon. Causes of financial contagion such as financial linkages and investor behaviour will be analysed, as well as the relationship between financial market contagion and noise trading via the information effect and asymmetries. Furthermore, the consequence of financial contagion on emerging markets and developed markets will be explained. In Section II, the reconciliation of the phenomenon of noise trading with the concept of an efficient market will be examined. This will be achieved through a discussion in which the definition of an efficient market is ascertained by comparison of the most widely accepted forms of the Efficient Market Hypothesis (EMH), a modern financial paradigm. This will be followed by the comparison of noise traders and information traders, in the context of a discussion based on the EMH, illustrating the mechanism that underlines the market’s entire foundation, and further results in an efficient market. Section III then seeks to explain the implications of noise trading on the financial market and...
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