Noise Trader Risk: Evidence from the Siamese Twins

Abstract

This paper provides new evidence regarding the magnitude and nature of noise trader risk. I examine returns for two pairs of Siamese twin stocks: Royal Dutch/Shell and Unilever NV/PLC. These unusual pairs of fundamentally identical stocks provide a unique opportunity to investigate the nature of noise trader risk. I investigate two facets of noise trader risk: (1) the fraction of total return variation unrelated to fundamentals (i.e., noise), and (2) the short-run risk borne by arbitrageurs engaged in long-short pairs trading. I report evidence that 30% of daily return variation and 10% of monthly return variation is attributable to noise. Noise trader risk comes in both systematic and firm-specific varieties, and varies considerably over time. The conditional volatility of long-short portfolio returns ranged from 0.4% to 1.6% per day during the 1989-2003 sample period. Noise trader risk was especially high around the failure of Long-Term Capital Management in 1998 and during the collapse of the technology bubble in 2000. I conclude that noise trader risk is a significant limit to arbitrage.

Keywords: Noise trader risk, Market efficiency, Limits to arbitrage, Behavioral finance, Hedge funds

JEL Classification: G12, G14