Signal or Noise? Uncertainty and Learning about Whether Other Traders are Informed
Northwestern University - Kellogg School of Management - Department of Finance
Brett S. Green
University of California, Berkeley - Haas School of Business
We develop a model in which some traders are uncertain whether other market participants are trading on informative signals or noise. This uncertainty generates a non-linear price that reacts asymmetrically to news. We incorporate this uncertainty into a dynamic setting where traders gradually learn about others and show that this leads to rich return dynamics: expected returns and volatility are stochastic but predictable, and volatility exhibits clustering in which large return realizations are followed by higher volatility and returns. The model also highlights an important link between information quality and disagreement, which helps reconcile conflicting evidence from previous empirical studies.
Number of Pages in PDF File: 45
Keywords: Asset Prices, Learning, Asymmetric Information, Rational Expectations, Noise Trading, Sentiment
JEL Classification: G12, G14working papers series
Date posted: September 2, 2012 ; Last revised: January 22, 2014
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