INTRODUCTION
Economic theories are propounded by financial analysts,
economists, scholars and various schools of thoughts. The noise model was
propounded by Fisher Black who argued extensively on his works and beliefs. He
posits how noise in the financial market and how traders view noise from
different perspectives could affect their trading and investment. What
constitutes noise to one trader may constitute information to the other.
We view and hear things individually in our own perspectives and this
largely has an effect on our individual and professional lives. Just like those
who see a glass of water as half full and others see it as half empty, that is
how Fisher Black’s noise theory was largely accepted by some economists and at
the same time rejected by others.
The objective of this essay is to explain
why black argues that noise is a necessary, structural ingredient of markets
and discuss the consequences of this argument for the notion that markets are
efficient. In a bid to elucidate on Black’s Noise model, some scholars and
authors opinions will be used for further analysis.
DEFINITION OF NOISE
Before
going further, it is appropriate to explain what noise is and who a noise
trader is. Noise has been discussed extensively by finance and economics
experts over time. The general consensus is that noise is dubious information,
noise is gossip, noise is speculation concerning the price and potential events
that could affect stock prices. In that sense a noise trader is someone who
trades based on speculation. In his model of inflation, Black argues that noise
is the arbitrary element in expectations that leads to an arbitrary rate of
inflation consistent with expectations. In his model of business cycles and
unemployment, he defines noise ‘as information that hasn't arrived yet’. He
sees these models as equilibrium models, but the existence of noise compels him
to deem them irrational equilibrium models.
Noise is more of the rumours making
the rounds in the financial market. It
is more or less the invisible hand
“unobservable market force that helps the demand and supply of
goods”.
I
will personally define noise as distorted data available in the financial market
where many traders processed into meaningful and unmeaningful information for
trading. Finally, noise is one of the constituent forces that drive the market
to and fro.
DISCUSSION
Black’s biggest
argument regarding the importance of noise is its effect on liquidity. Although
noise makes financial markets imperfect, it makes trading possible. Trading
takes place because two traders have opposing views or beliefs. This is mainly
possible due to the existence of noise as it is possible that one party is
trading based on actual information and the other based on noise. Without noise
there will rarely be individual trading. Black says people will prefer to trade
in mutual funds or portfolios, but a lack of trading in individual markets like
Black says means no trading in mutual funds as there would be no practical way
of pricing them.
One
of the reasons why noise in the financial market can’t be overlooked is because the
various choices in decision (i) are risk averse: riskless prospect is preferred to a risky
prospect of equal or greater expected value. Also, the popular choice in
decision (ii) is risk taking: a risky prospect is preferred to a riskless
prospect of equal expected value (Amos T., & Daniel K., 1981). For instance,
the recent fall in shares of facebook in the New Yoke Stock Exchange is as a
result of noise and people traded based on that noise that there was a bread of
data, thus the Bullish trend of the shares wouldn’t be sustained as the Bears
are ready to take over the market.
People’s
forecasts in everyday life as well as
in their business lives, in this case financial markets, are frequently established
on the assumption of human reasonableness.
Because of imperfections of human observation and assessment, however,
changes of perspective often reverse the relative desirability of options (Tversky
& Kahneman, 1981).
The
possibility that some traders are more well-informed about the market may
motivate a less informed traders to try and infer information from past or even
current trades of others, leading to informational cascades - this argument echoes
the work of Tversky and Kahneman (1981) who argued that traders tend to make
decisions where they expect the distribution of a small sample or short time
series to be representative of that of the population.
One
major causes, is the trader concentration, whereby traders do not have the competence
to explore all assets accessible to them for their advantages, and may simply
focus on the ones that have caught their interest. Also, the disposition effect, where traders tend to
avoid the regret related to selling losing investments, thus sell winning ones
instead.
The
forex market which is one of the largest financial markets in the world is a
prime example where traders take trades based on feeds. In no time, these traders would be thinking of
placing a stop loss, and trading the opposite.
Devenow
& Welch, (1996), in a well structured market where noise is less, informative (true) signals received by better
traders or investors are correlated, whereas uninformative signals (noise)
received by worse traders or investors are not.
Brennan
(1990) cited in Devenow & Welch, (1996), traders have a limited lifespan in
an infinite, overlapping generations model. The true value is sometimes
revealed exogenousl. Private information is reflected in stock prices one
period after it is acquired, but only if a minimum number of traders have
acquired it.
Therefore,
expected gains to purchasing information depend on an assessment of others'
expected gains (and the probability of exogenous value revelation), and two
equilibria obtain. In one equilibrium,
no one purchases information because information is unlikely to be reflected in
the stock price.
The existence of
noise traders makes actually informed traders want to trade more as they want
to take advantage of “idiot traders” as Paul Krugman (2009) calls them. This
increases liquidity even further.
Kyle in his (1984)
paper shows using a model that equilibrium exists in the presence of noise
further proving Black right. In fact Stiglitz and Grossman’s (1980) model shows
that an increase in noise increases the proportion of informed traders. Kyle
goes a step further by proving using his model of imperfect competitive markets
that noise makes prices more informative as noise trading increases the
liquidity (a view shared by Black) of the market where liquidity is
proportional to the number of trades it takes to change price by one dollar.
One may argue that
noise traders will cause the price of an asset to wander away from its value
thereby making the market inefficient. Black argues that this will not be the
case as information traders will offset this by taking more and more positions
in order to benefit from the price imperfection thereby moving price back to
its original value.
Kyle (1984) proved
this with his model and concluded that an increase in noise has no effect on
the informativeness of prices given informed speculators are constant. He
explains that this happens because speculators scale up their activities
proportionally as noise trading increases thereby maintaining the equilibrium.
He concludes that
an increase in noise trading stabilizes prices by shifting less volatility into
the present than is shifted into the future.
Grossman and
Stiglitz (1980) say the number of informed and uninformed individuals will
depend on certain parameters; the cost of information, the informativeness of
information and the efficiency of information. Two of these if not all three
are affected by noise, isn’t this in itself further proof that in the imperfect
world we live in, all traders are noise traders? This further highlights the
importance of noise traders.
Thus, methods of
parsing noise and information from a signal are becoming increasingly important
in the market-place, especially as strategies used by high-tech alternative
investment firms, such as some hedge funds. People exhibit patterns of preference,
which appear incompatible with expected utility theory (Wu et al, 2013).
It is of Truth that noise is part and parcel of the
financial market. Noise forms the entire element of the financial market.Most
noise in the financial market, responds to the random onset of new information,
which shows up in the Brownian motion-like small random changes in stock
prices. Larger, Levy flight-like changes in stock prices are often mistaken for
noise, but really represent a different phenomenon altogether (Belch, G.E,
2012).
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