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June 11, 2005

Notes: URAP Project 1: Fall 2005: Noise Traders

URAP Project: Toward a Taxonomy of Noise Trader-Generated Financial Market Failure

Time to start setting out potential projects for undergraduate research assistants for the forthcoming fall...

Here's one possibility: one that requires somebody with good algebra and simulation skills:

Start from: J. Bradford DeLong, Andrei Shleifer, Lawrence Summers, and Robert Waldmann (1990), "Noise Trader Risk in Financial Markets, Journal of Political Economy 98, 703-738.

The idea is to use the model of DSSW (1990), related models, and simulations, to try to make progress on the circumstances under which we would expect to see financial markets perform well and badly as social capital allocation mechanisms that feed prices to the rest of the economy.

The first question to be approached would be the effect of increasing fundamental uncertainty on the ability of a financial market to "weed out" peole who trade on bad information. The market, after all, aggregates information--and it cannot give reliable price signals if the information that it aggregates is bad, can it? Implicit in DSSW is the prediction that increasing fundamental uncertainty can destroy a financial market's abiity to weed out or even keep a lid on bad information. But how robust is this prediction? And what other predictions are there?

This URAP project would jump off from DSSW (1990), a twenty-page background memo that sketches out the connection between the ability of a DSSW-type financial market to keep a lid on noise trading and the amount of fundamental risk, and an old Excel spreadsheet used to do a little algebra and simulations.

http://www.j-bradford-delong.net/movable_type/pdf/Noise_Trader_Background.pdf
http://www.j-bradford-delong.net/movable_type/pdf/Noise_Traders_Main.pdf
http://www.j-bradford-delong.net/movable_type/xls/Noise_Trader_Risk.xls

Posted by DeLong at June 11, 2005 08:09 AM