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 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 find that about 15% of weekly return variation is attributable to noise. Noise trader risk has both systematic and idiosyncratic components, and varies considerably over time. The conditional volatility of long-short portfolio returns ranged from 0.5% to over 2.75% per week 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