Uninformed Trading and Asset Prices

Abstract

This paper examines the relationship between uninformed trading and asset prices. We outline a simple market clearing model in which some traders have demands shocks that are uncorrelated with asset fundamentals. We verify the predictions of the model empirically using an untapped dataset that allows ex ante identification of uninformed demand shocks. Our results show pervasive price pressure at a daily, weekly and monthly frequency. A zero-cost portfolio based on past uninformed trades earns up to 171 bp (before transaction costs) over the subsequent three week period. Returns of this zero-cost portfolio cannot be explained by known sources of systematic risk. Within the same modeling framework, we show that uninformed trading is also related to permanent price differences across stocks. Stocks that are subject to more volatile uninformed trading earn higher average returns. Our results provide insights into the limits of arbitrage and a market's ability to absorb aggregate demand shocks.

Keywords: Asset pricing, return predictability, limits of arbitrage

JEL Classification: G12