Trading on Information About Noise in Financial Markets

Many investors in financial markets are relatively inexperienced. Much of the literature focuses on the incentives of sophisticated informed agents to produce information about future cash flows, and not on agents that attempt to acquire information about the trades of naive agents. However, unsophisticated agents are important aspects of financial markets and worth analyzing further. In this paper, we provide a theoretical perspective that addresses trading based on private information about the trades of naive investors. We analyze the effect of such information on liquidity costs, price efficiency, and volatility. We show that the optimal acquisition of information about noise traders balances the extent of informed trading and the direct benefits from noise acquisition. When management possesses information about the activities of noise traders, the optimal disclosure strategy of management depends on whether existing shareholders are helped or harmed by enhanced informational efficiency. When shareholders own shares in private firms, disclosure is optimal to allow private firms to allocate resources more efficiently. On the other hand, when private firms are acquisition targets managers prefer to not disclose noise trades to lower the acquisition price.