Time-Varying Noise Trader Risk and Asset Prices

By introducing time varying noise trader risk in De Long, Shleifer, Summers, and Waldmann (1990) model, we predict that noise trader risk significantly affects time variations in the small-stock premium. Consistent with the theoretical predictions, we find that when noise trader risk is high, small stocks earn lower contemporaneous returns and higher subsequent returns relative to large stocks. In addition, noise trader risk has a positive effect on the volatility of the small-stock premium. After accounting for macroeconomic uncertainty and controlling for time variation in conditional market betas, we demonstrate that systematic risk provides an incomplete explanation for our results. Noise trader risk has a similar impact on the distress premium.

Paper

Time-varying Noise Trader Risk and Asset Prices (as PDF file, 135 KB)