Can Noise Create Size and Value Effects?

32 Pages Posted: 10 Oct 2006 Last revised: 26 Oct 2011

See all articles by Robert D. Arnott

Robert D. Arnott

Research Affiliates, LLC

Jason C. Hsu

Rayliant Global Advisors; Research Affiliates, LLC; University of California, Los Angeles - Anderson School of Business

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Harry Markowitz

University of California at San Diego

Date Written: October 24, 2011

Abstract

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.

Keywords: noise, size effect, value effect

JEL Classification: G12, G14

Suggested Citation

Arnott, Robert D. and Hsu, Jason C. and Liu, Jun and Markowitz, Harry, Can Noise Create Size and Value Effects? (October 24, 2011). AFA 2008 New Orleans Meetings Paper. Available at SSRN: https://ssrn.com/abstract=936272 or http://dx.doi.org/10.2139/ssrn.936272

Robert D. Arnott

Research Affiliates, LLC ( email )

620 Newport Center Dr
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949-325-8700 (Phone)
949-325-8901 (Fax)

HOME PAGE: http://www.researchaffiliates.com/Our%20Firm/Our%20Team/Pages/Rob-Arnott.aspx

Jason C. Hsu

Rayliant Global Advisors ( email )

Hong Kong

Research Affiliates, LLC ( email )

620 Newport Center Dr
Suite 900
Newport Beach, CA 92660
United States

HOME PAGE: http://www.jasonhsu.org

University of California, Los Angeles - Anderson School of Business

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Jun Liu (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

Harry Markowitz

University of California at San Diego ( email )

9500 Gilman Drive
La Jolla, CA 92093-0508
United States
(858) 534-3383 (Phone)

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