Behavioral Finance

CHAPTER 6

Noise Trading Feedback Models

Supporters of the efficient market hypothesis (EMH) would argue that firms need not worry about noise traders creating short-term price movements that do not reflect underlying fundamentals because those mispricings would quickly get corrected by rational agents in the market. However, the Shleifer model discussed in the previous chapter demonstrated conditions under which rational traders may not be able to correct prices enough to truly reflect fundamentals, disrupting the implications of the EMH.

Feedback models attack the same EMH conclusion but from a different angle. In these models, movements in a firm's price affect the decisions of other rational agents related to the firm, such as suppliers, customers, or employees, which changes the underlying value of the firm itself. Such models would not argue that a firm's price might not revert back to fundamentals; instead, they argue that the fundamental value to which it reverts back may be different than it was before the stock price moved at all. In other words, price movements “feed back” into the underlying value of the firm.

One such model is the Hirshleifer model, in which feedback effects from noise trading not only impact financial markets, but also have real economy effects, such as on production effort and resource allocation. The second model explored here examines feedback effects that impact a firm's affiliates, which have a degree of complementarity across them. In this model, ...