What to do about excessive volatility
Seminar Room 1, Newton Institute
Our objective in this paper is to determine and analyze the trading strategy that would allow an investor such as a hedge fund to take advantage of the excessive stock price volatility that has been documented in the empirical literature on asset pricing. To achieve our objective, we first construct a general equilibrium model where stock prices are excessively volatile. We do this using the same device as in Scheinkman and Xiong (2003) where there are two classes of agents and one class is overconfident about the value of the signal. We then analyze the trading strategy of the rational investors who is not overconfident about the the signal. We find that the portfolio of rational investors consists of three components: a static (i.e., Markowitz) component based only on current expected stock returns and risk, a component that hedges the investor against future revisions in the market's expected dividend growth, and a component that hedges against future disagreement in revisions of expected dividend growth. That is, while rational risk-arbitrageurs find it beneficial to trade on their belief that the market is being foolish, when doing so they must hedge future fluctuations in the market's foolishness. Thus, our analysis illustrates that risk arbitrage cannot be based on just a current price divergence; the risk arbitrage must include also a protection in case there is a deviation from that prediction. We also find that the presence of a few rational traders is not sufficient to eliminate the effect of overconfident investors on excess volatility. Moreover, overconfident investors may survive for a long time before being driven out of the market by rational investors.