Strategic Trading with Naive Noise Traders

Abstract:     
We investigate a dynamic model of speculative trading in which a naive noise trader is born each period who uses a simple strategy, whereas a rational informed investor maximizes her profits by strategically exploiting the successive noise trading over time. The model shows that the two types of traders will soon hold opposite views on whether the current price is high or low relative to its fundamental value. The informed trader simultaneously submits an "information trade" to exploit asymmetric information and an "arbitrage trade" to exploit heterogeneous beliefs between the two types every period. The heterogeneous beliefs render a unique source of liquidity, thus magnifying informed profits and the total trading volume. It is shown that a monopolistic informed trader may ride on noise trading in early periods to push the price away from its fundamental value, only to reap greater profits by her later arbitrage trades. Such strategic behavior in arbitrage, however, disappears under imperfect competition. Unlike previous models with exogenous noise (liquidity) trading, our model with endogenous noise trading can better explain the high trading volume phenomenon and the familiar U-shaped pattern in intraday transaction costs and price volatility.

Number of Pages in PDF File: 42

working papers series