Principles of Finance: Comparison and Contrast between 'Noise Trader' and 'Efficient Markets' Approaches to Pricing in Financial Markets

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How important is Pricing? In financial markets, prices reflect a volume of aggregate information. In order to understand and make inferences in the financial market, pricing is a significant mechanism to understand the financial market. Surprisingly, pricing models have only been a major research subject since the sixties. As pricing is the determinant of the price, pricing models try to reflect reality. By reflecting reality, a price assists in good investment decisions. A consensus has been drawn on the formation of prices on financial markets and two schools of thought coexist. The first school of thought or model is based on the efficient market theory. A market is efficient if prices in the market perfectly and instantly reflect all available information. Experiences that have been instituted to test market efficiency have produced various results and one can almost and always decide that the results stand for or against the market efficiency theory. Moreover, testing market efficiency is similar to the process of testing a joint hypothesis as it is impossible to test market efficiency prior to testing a pricing model. In this essay, I will try to present and compare each pricing model. This will lead me to determining whether they meet their goals or not.

Extraits

[...] Principles of Finance: Comparison and Contrast between 'Noise Trader' and 'Efficient Markets' Approaches to Pricing in Financial Markets Introduction On financial markets prices reflect a volume of aggregate information, thus pricing is an essential mechanism to understand financial markets. Surprisingly pricing models have only been a major research subject since the sixties. As pricing is the determination of the price, pricing models try to: - reflect reality - help to make good investment decisions There is no consensus about formation of prices on financial markets and two schools of thought coexist. [...]

[...] Another paradox is that trade should disappear or be very small on markets as all investors should want to sell and buy the same securities; nevertheless the amount of securities exchanged on markets is huge and increasing. Consequently we can suppose that all investors do not trade perfectly rationally. Introduction of sentiments in the market: behavioural finance and the noise trader approach Various experiments and econometrics studies have been conducted and revealed some anomalies about rational pricing on financial markets. Some of them are known as “January effect” or “small-cap effect”. [...]

[...] Waldmann On the Impossibility of Informationally Efficient Markets, Sanford Grossman and Joseph Stiglitz, American Economic Review Principles of Corporate Finance, Richard Brealey and Stewart Myers, chapter The end of behavioural finance, R. Thaler, Financial Analysts journal, nov- dec 1999 The noise trader approach to finance, A. Shleifer and L. Summers, Journal of economic perspectives, spring 1990 Principles of Corporate Finance, Richard Brealey and Stewart Myers, chapter 13, p259. A diagram showing successive returns of General Motors stock on two following days show no correlation between successive records. [...]

[...] Behavioural finance introduces sentiments and human behaviours in the pricing process. All investors are influenced by behavioural factors such as overconfidence or get-evenitis (loss aversion)[2] which impact on pricing. The noise trader approach considers that prices are determined by information but as all investors are not rational, prices can deviate from fair value. The noise trader approach considers two kinds of investors who do not trade for the same reasons. On the one hand arbitrageurs act like rational investors, conformly to the efficient markets theory. [...]

[...] These conditions are “First, in dollar-weighted terms, such a market cannot have too many quasi's [rational investors] (in order for the rational investor to be marginal). Second, the market must allow costless short selling (so that if prices get too high, the rationals can drive them down). Third, only rational investors can sell short; otherwise, the quasi's[rational investors] will short Y when the two prices are the same because they believe X is worth more than Y. Fourth, at some date the true relationship between X and Y must become clear to all investors. [...]