Can Noise Create Size and Value Effects?
Robert D. Arnott
Research Affiliates, LLC
Jason C. Hsu
Research Affiliates, LLC; University of California, Los Angeles - Anderson School of Business
University of California, San Diego (UCSD) - Rady School of Management
University of California at San Diego
October 24, 2011
AFA 2008 New Orleans Meetings Paper
The price of a stock may differ from its fundamental value by a random noise. In this case, small-capitalization and value stocks are more likely to have negative noise, while large-capitalization and growth stocks are likely to have positive noise. Negative price noise implies that small-capitalization and value stocks are more likely undervalued and thus have higher expected return than justified by risk, while the large-capitalization and growth stocks are more likely overvalued. We formally verify and explore this intuition by using a standard noise-in-price model.
We compute in closed form the cross-sectional variations of the expected stock return. Our model is parsimonious with essentially only one adjustable parameter the volatility of the price noise.
With a moderate volatility of price noise, the cross-section of the expected stock return matches quantitatively the empirical counterpart in Fama and French (1992). Our study suggests that a modest amount of noise in prices can create size and value effects.
Number of Pages in PDF File: 32
Keywords: noise, size effect, value effect
JEL Classification: G12, G14working papers series
Date posted: October 10, 2006 ; Last revised: October 26, 2011
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