The Limits of Noise Trading: An Experimental Analysis

Abstract

In this research we investigate the behavior of noise traders and their impact on the market. We do this in an experimental market setting that allows us to determine not only how noise traders fare in a competitive asset market with other traders, but also how the equilibrium changes if a securities transactions tax ("Tobin tax") is imposed. We find that noise traders lose money on average: they do not engage in extensive liquidity provision, and their attempt to make money by trend chasing is unsuccessful as they lose most in securities whose prices experience large moves. Noise traders adversely affect the informational efficiency of the market: they drive prices away from fundamental values, and the further away the market gets from the true value, the stronger this effect becomes. With a securities transaction tax, noise traders submit fewer orders and lose less money in those securities that exhibit large price movements. The tax is associated with a decrease in market trading volume, but informational efficiency remains essentially unchanged and liquidity (as measured by the price impact of trades) actually improves. We find no significant effect, however, on market volatility, suggesting that at least this rationale for a securities transaction tax is not supported by our data. 2 The Limits of Noise Trading: An Experimental AnalysisNoise traders play a ubiquitous role in the finance literature. Fischer Black [1986] dedicated his AFA presidential address to the beneficial effects of "noise" on markets, concluding that "noise trading is essential to the existence of liquid markets." Shleifer and and Shleifer and Vishny [1997] identified noise traders as the basis for the limits of arbitrage, arguing that noise trading introduces risks that inhibit arbitrageurs and prevent prices from converging to fundamental asset values. Noise traders in the guise of SOES bandits have been credited with enhancing price discovery (see Harris and Schultz [1998]), while their day trading counterparts have been disparaged for creating speculative bubbles in asset prices both home and abroad (Scheinkman and Xiong [2003]). The excessive volatility allegedly arising from noise trading is also blamed for a variety of economic ills ranging from market crashes to the failure of globalization. 1Despite this central importance, there remains considerable debate regarding the role of noise trading in financial markets. For example, there is little agreement as to whether noise trading enhances or detracts from informational efficiency; whether noise trading increases or decreases price volatility; or even whether noise traders can survive in financial markets, in either the short or the long run. This disagreement spills over into debates over whether society is well advised to limit noise trading by taxation or other means, or to ignore it altogether due to its inconsequential nature in affecting market outcomes.Undoubtedly, the confusion surrounding the role of noise traders stems in part from basic disagreements over ...

Noise Trading and Illusory Correlations in US Equity Markets*

“…Noise traders have been a key component of financial models since their introduction by Kyle (1985) and Glosten and Milgrom (1985) because they help markets avoid no-trade equilibria Stokey, 1982, Morris, 1994), Bloomfield, et al (2005) asserts that "noise traders play a ubiquitous role in the finance literature"; Kalay and Wohl (2005) describe them as "an integral part of modern microstructure theory".…”

The economic consequences of a Tobin tax—An experimental analysis

“…to introduce a securities transaction tax (Bloomfield et al, 2006). Although the tax revenues are often downplayed as "side-effects", expected fiscal benefits obviously also increase the political appeal of a Tobin tax.…”

“…The latter paper stresses that the interplay between liquidity and volatility (via the price impact of orders) is difficult to assess in practice, so Westerhoff and Dieci (2006) explicitly call for an experimental analysis of the question. Bloomfield et al (2006) run a controlled laboratory experiment to study trading behavior on markets when a securities transaction tax (STT) is introduced. They are particularly interested in the effects of a STT on three different types of traders which they call informed traders, liquidity traders, and noise traders.…”

“…Market volume is driven down by the tax, whereas market volatility is hardly affected. A limitation of the setting used in Bloomfield et al (2006) is its restriction to only a single market, though.…”

Trader Positions and Marketwide Liquidity Demand

“…But, consistent with their results, we also find that passive trading lowers market liquidity, suggesting that passive orders carry information. Bloomfield, O'Hara and Saar (2005) use an experimental design to argue that informed traders use both market and limit orders to fully capitalize on their information.…”