Calculate the impact on price of an increasing proportion of noise traders

entering the market from the following set of information: Dividend: 25% of value;
Current level of optimism: 6% of value; Average Optimism: 3% of value; Variance:
20%; % of Noise traders in market: 33%; Risk aversion coefficient: 0.30

To calculate the impact on the price of an increasing proportion of noise traders

entering the market, we need to consider the effect of noise traders on market
dynamics. Noise traders are investors who make trades based on imperfect or
inaccurate information, which can introduce volatility and affect prices.

Given the information provided, we can start by determining the equilibrium price in
a rational market (without noise traders), and then compare it to the price in a
market with noise traders. We'll use a simple model assuming rational expectations.

Let's denote:

 𝐷D = Dividend (25% of value)

 𝑂O = Current level of optimism (6% of value)
 𝐸[𝑂]E[O] = Average optimism (3% of value)
 𝜎2σ2 = Variance of optimism (20%)
 𝛼α = Proportion of noise traders in the market (33%)
 𝛾γ = Risk aversion coefficient (0.30)

In a rational market, the price (𝑃P) is determined by the discounted present value of
future dividends and expected future optimism:

𝑃=𝐷𝑟+𝐸[𝑂]

Where 𝑟 is the discount rate.

We can calculate 𝑟r using the risk-free rate (𝑟𝑓) and the market risk premium (𝜆):

𝑟=𝑟𝑓+𝛾𝜆

Given the information provided, let's assume 𝑟𝑓=6 and 𝜆=12 (assuming the market
return is 12% and the risk-free rate is 6%).

So, 𝑟=0.06+0.30×0.06=0.078

Now, let's calculate the rational market price:

𝑃=0.25/0.078+0.030/0.078≈3.2+0.39≈3.59

This is the equilibrium price in a rational market.

Now, to calculate the impact of noise traders, we need to consider their effect on
market sentiment. Noise traders can cause fluctuations in market sentiment and
affect prices based on their imperfect information and irrational behavior.

One way to model this is by adjusting the expected future optimism. Let's denote the
adjusted expected future optimism ( 𝐸′[𝑂]) as:

𝐸′[𝑂]=(1−𝛼)×𝐸[𝑂]+𝛼×𝑂

Where 𝛼α is the proportion of noise traders in the market.

Substituting the values, we get:

𝐸′[𝑂]=(1−0.33)×0.03+0.33×0.06=0.02+0.0198=0.0398

Now, let's recalculate the price with the adjusted expected future optimism:

𝑃′=0.25/0.078+0.0398/0.078≈3.2+0.51≈3.71

So, the price in a market with noise traders is approximately $3.71. Therefore, the
impact of noise traders entering the market increases the price by approximately
$0.12 (3.71 – 3.59).
Calculate the subjective decision-making weights through Benartzi & Thaler equation
by mapping probabilities of 1% & 99.9% with weights of 0.61 for probabilities
a t t a c h e d t o p ro s p e c t i v e g a i n s a n d 0 . 69 f o r p r o s p e c t i v e l o s s e s .

Benartzi and Thaler's formula for subjective decision-making weights adjusts

probabilities of extreme outcomes (such as 1% and 99.9%) to prevent overweighting
or underweighting of rare events.

The formula is:

𝑊(𝑝)=𝑝𝛽/𝑝𝛽+(1−𝑝) 𝛽

Where:

 𝑊(𝑝) = subjective decision-making weight for probability 𝑝

 𝛽 = weighting function parameter (usually between 0 and 1)

Given that you have weights of 0.61 prospective gains and 0.69 for prospective
losses. Let's denote:

 For gains: 𝛽gain=0.61

 For losses: 𝛽loss=0.69

Now, let's calculate the subjective decision-making weights for probabilities of 1%

and 99.9% for both gains and losses. Given:

 𝑝gain=0.01 (1% probability)

 𝑝loss=0.999 (99.9% probability)

Let's calculate the subjective decision-making weights for both gains and losses:

For gains: 𝑊(𝑝gain) = 0.01^0.61/0.01^0.61+(1−0.01)^0.61 ≈ 0.0669

For losses: 𝑊(𝑝loss) = 0.999^0.69/0.999^0.69+(1−0.999)^0.69 ≈ 0.9988

So, the subjective decision-making weights for a 1% probability of gain is

approximately 0.0669 and for a 99.9% probability of loss is approximately 0.9988