: We consider a model of the stock market with delegated portfolio management. All agents are rational: some trade for hedging reasons, some investors optimally contract with portfolio managers who may have stock-picking abilities, and portfolio managers trade optimally given the incentives provided by this contract. Managers try, but sometimes fail, to discover profitable trading opportunities. Although it is best not to trade in this case, their clients cannot distinguish "actively doing nothing," in this sense, from "simply doing nothing." Because of this problem: (i) some portfolio managers trade even though they have no reason to prefer one asset to another (noise trade). We also show that, (ii), the amount of such noise trade can be large compared to the amount of hedging volume. Perhaps surprisingly, (iii), noise trade may be Pareto-improving. Noise trade may be viewed as a public good. Results (i) and (ii) are compatible with observed high levels of turnover in secur...

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Policy towards speculative bubbles is examined in a model of a Þnite horizon “greater fool ” bubble, with rational agents, asymmetric information and short-sales constraints. This model permits the use of standard tools of comparative dynamics and welfare economics to analyze bubble policies. Government policy is modeled as deßating overpriced assets by revealing information about this overpricing. We assume in this paper that the central bank only deßates assets if they are, in fact, overpriced. However, the central bank is never the only one to know that assets are overpriced. In this environment, a policy rule of deßating overpriced assets also inßuences expectations in states of the world where the central bank does nothing. That is, if the central bank is following a bubble-bursting rule, then the market interprets inaction as an implicit endorsement of asset prices, which raises these prices. This can reduce the lemons problem caused by asymmetric information, if prices rise because the policy protects uninformed buyers from “bad sellers ” who know assets are overpriced. However, if the central bank only deßates “strong bubbles, ” where all investors already know the asset is overpriced, then inaction raises prices because bad sellers become more conÞdent, and this tends to make the lemons problem worse. * The paper beneÞtted greatly from discussions with Franklin Allen, Mike Belongia,