Limits of Arbitrage and Noise Trading
Noise trading is trading on noise as if it were information (Black, 1986, p. 531).
Noise traders are investors whose investment decisions rely more on psychological factors than on sound investment management principles (Andrikopoulos, 2007, p.
61).Misvaluations of financial assets are common in financial markets thus it is easy to reliably make abnormal gains from these misevaluations. There are two types of misevaluations: those that are recurrent or arbitrageable, and those that are nonrepeating and long-term in nature. As a result of misevaluations in the market, trading strategies can be profitable. Because of this, hedge funds and other smart investors search the market continuously, and keep them from ever getting too big. By this way, the market mechanism works efficiently. In long-term, it is nearly impossible to identify the peaks and troughs in real time until they have passed. And it is may be very risky. For example; getting into early risks causes losses that wipe out capital as it is in the Long Term Capital Management case. A worse situation is if limited partners or other investors are supplying funds, then withdrawals of capital after a losing streak may result in buying or selling pressure that exacerbates the inefficiency. Hedge funds may be accepted as a group of investors who positively affect market efficiency because they are in the search for misvalued assets in the markets and try to make money in this way. A relative value hedge fund takes long and short positions, buying undervalued securities and finding highly correlated securities that are overvalued, then takes arbitrage position. A macro hedge fund, on the other hand, takes speculative positions that cannot be easily hedged, such as shorting NASDAQ during the last two years (Ritter, 2003, p. 434).
Glaser, Noth and Weber surveyed the literature about arbitrageurs and their effect in market efficiency.
They argued that the effect of arbitrageurs is limited in financial markets, at least in the short horizon (Glaser et al., 2004, p. 6).The following is a good example of the limits of arbitrage in the financial markets which is mentioned in the preceding paragraphs: The case of Royal Dutch Shell. In the beginning Royal Dutch Petroleum and Shell Transport and Trading are independently incorporated in the Netherlands and England respectively. The current firm emerged from a 1907 alliance between Royal Dutch and Shell Transport and Trading. The new firm has been 60% owned by Royal Dutch Petroleum and 40% owned by Shell Transport and Trading. Royal Dutch trades primarily in the US and the Netherlands and Shell trades primarily in London. According to rational models, the shares of these two companies (after adjusting for foreign exchange) should trade in a ratio of 60:40. But they do not. The actual price ratio has deviated from the expected one by more than 35% for more than a year. It does not make sense to explain this disparity with taxes and transaction costs. According to Froot and Dabora stock prices are affected from the location of trade (Froot & Dabora, 1999, p.13). This is the violation of the law of one price and is a simple, but well known example illustrating that prices can diverge from intrinsic value because of the limits of arbitrage rule (Glaser et al., 2003, p. 5). Some investors do try to exploit this mispricing, buying the cheaper stock and shorting the more expensive one, but this is not a sure thing, as many hedge funds learned in the summer of 1998 (Mullainathan & Thaler, 2000, p. 8).
The crucial assumption on which EMH depends is that the beliefs of human beings are rational. This is consistent with the widely accepted economic theory which postulates that rational decision-makers search for the option which has the largest subjective expected utility, determined by reference to probabilities derived from the available information set.
Economists have long resisted the possibility that human beings may act irrationally in the market setting, which is a large part of the foundational stone of agents rationality in the EMH. Irrational behavior that interferes with market efficiency has become known as “noise” (Glen, 2005, p. 97). According to Black; noise is the opposite of information. Investors in financial markets mainly trade on noise as it is information causing inefficiencies in the financial markets (Black, 1986, p.529).Noise refers to those pricing influences that are not associated with rational expectations about the underlying value of the asset (Glen, 2005, p. 98). Such expectations are not necessarily rational. They should not be. Investment strategies based on noise may represent anything from loyalty to a friend to a personal heuristic. The noise theory is not so concerned with why individual investors show these suboptimal actions, but rather the effect of irrational behavior on the market (Glen, 2005, p. 98).
Noise theory models “hold that the public capital markets are infected by a large volume of trading based on information unrelated to fundamental asset values. These trades are largely undertaken because of underlying emotional or psychological impulses unrelated to the asset’s value. Besides, most investors do not have the capacity or inclination to make comparative investment decisions independently, making them susceptible to external expressions of experts and peers. In the end, even if a public capital market is efficient in the sense of swiftly incorporating public information into security prices that does not necessarily mean that securities prices in that market reflect fundamental values. Although Noise Theory has recently received extra attention, the notion itself is old, dating to John Maynard Keynes. Keynes assumed that investors on the whole were not conducting fundamental analysis, but rather, were more apt to act based on information unrelated to the fundamental value of the particular asset.
The central idea of noise theory is that information unrelated to fundamental values has an impact on the prices of capital assets. However, this is not noise theory’s most important contribution to modem economic analysis. The “more important implication of noise theory is that it reveals markets to be nonlinear systems, to which the linear mathematics and reasoning that underlie the EMH are inadequate (Glen, 2005, p. 99).
Black introduced the concept of noise traders to finance literature. Noise traders have an impact in financial markets, and trade on anything other than information. Black highlighted that noise trading is essential to the existence of liquid markets. It is noteworthy that noise may be the main reason of inefficiencies in financial markets but it also makes them possible. As noise trading makes the market more liquid by improving trading volume in the market (Black1986, pp. 531).
In financial markets, there is always a group of investors investing through the advice of financial gurus; they trade actively on the stocks or base their trading strategies on price patterns and other popular models (Cornicello, 2004, p. 22).
It can be argued that noise traders generally lose money in the markets while information traders often earn a profit. The presence of noise traders in the market also influences market prices. Of course, the higher the number of noise traders in the market, the greater their influence on asset prices, even though it would be more profitable for people to trade on information. However, it should be emphasized that if it is not easy to take positions against noise traders as information traders would fail to correct the mispricing and to earn a profit (Ritter, 2003, p. 431).
The presence of noise traders in financial markets and the effect of their trades on the market are closely related with the arbitrage possibilities. The efficient market hypothesis explains that the presence of the irrational investor is deleted by the rational arbitrageurs who cut out the irrational investor’s influence on stock prices.
In financial markets, arbitrage opportunities are risky and therefore limited. The opportunities for arbitrage are based on close substitutes for the security in which noise traders invest. It is not easy for an arbitrageur to take position and eliminate the mispricing effects of noise traders, especially in the short run (Ritter, 2003, p. 431). These are usually available for derivative securities, like options or futures, but occasionally the arbitrage requires notable trading volume. In other cases, there are no close substitutes. An arbitrageur cannot sell stocks and buy a substitute portfolio at the same time because this simply does not exist. In this case, the arbitrageur can only sell or lessen his exposure to the stocks, but this arbitrage is not risk-free, and if the investor is risk adverse, his interest in this arbitrage will be limited. There are two main difficulties for this type of trading strategy. First, arbitrageurs cannot take an adequate amount of positions in order to offset the effects of noise because of the increasing risk. As information gives him an opportunity but does not guarantee the profit. Taking larger positions will increase the risk and this will limit the arbitrageur. Secondly, the arbitrageur can never be sure if he is trading on information or noise. If the information used has already been included in prices then he will be trading on noise. In this situation one can never be sure until it comes through. Consequently, the presence of arbitrageurs on the market does not eliminate the effect of the noise traders because of the limits of arbitrage in financial markets (Black, 1986, p. 532).