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Principles of Finance: Comparison and Contrast between 'Noise Trader' and 'Efficient Markets' Approaches to Pricing in Financial Markets

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  1. Formation of prices according to fundamental analysis: the efficient market approach
  2. Introduction of sentiments in the market: behavioural finance and the noise trader approach
  3. Knows fundamental value useful to beat the market?
  4. Which model better reflect reality of pricing?

How important is Pricing? In financial markets, prices reflect a volume of aggregate information. In order to understand and make inferences in the financial market, pricing is a significant mechanism to understand the financial market. Surprisingly, pricing models have only been a major research subject since the sixties. As pricing is the determinant of the price, pricing models try to reflect reality. By reflecting reality, a price assists in good investment decisions. A consensus has been drawn on the formation of prices on financial markets and two schools of thought coexist. The first school of thought or model is based on the efficient market theory. A market is efficient if prices in the market perfectly and instantly reflect all available information. Experiences that have been instituted to test market efficiency have produced various results and one can almost and always decide that the results stand for or against the market efficiency theory. Moreover, testing market efficiency is similar to the process of testing a joint hypothesis as it is impossible to test market efficiency prior to testing a pricing model. In this essay, I will try to present and compare each pricing model. This will lead me to determining whether they meet their goals or not.

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