How Noise Trading Affects Markets: An Experimental Analysis

63 Pages Posted: 20 Jun 2007  

Robert J. Bloomfield

Cornell University - Samuel Curtis Johnson Graduate School of Management

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management

Gideon Saar

Cornell University - Samuel Curtis Johnson Graduate School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: May 2007

Abstract

We use a laboratory market to investigate the behavior of noise traders and their impact on the market. Our experiment features informed traders (who possess fundamental information), liquidity traders (who have to trade for exogenous reasons), and noise traders (who do not possess fundamental information and have no exogenous reasons to trade). We find differences in behavior between liquidity traders and noise traders, justifying their separate treatment. We find that noise traders exert some positive effects on market liquidity: volume and depths are higher and spreads are lower. We provide evidence suggesting that the main effect of the liquidity-enhancing trading strategies of the noise traders is to weaken price reversals (decreasing the temporary price impact of market orders) rather than to reduce the permanent price impact of trades (as liquidity traders supposedly do in market microstructure models with information asymmetry). We find that noise traders adversely affect the informational efficiency of the market, but only when the extent of adverse selection is large (i.e., when informed traders have very valuable private information). Finally, we examine how trader behavior and certain market quality measures are affected by a transaction tax. Although such taxes do reduce noise trader activity, they take a toll on informed trading as well. As a result, while taxes reduce volume, they do not affect spreads and price impact measures, and have at most a weak effect on the informational efficiency of prices.

Keywords: noise traders, liquidity traders, informed traders, experiments, experimental markets, market microstructure, informational efficiency, liquidity, transaction tax, Tobin tax

JEL Classification: G10, G12, G14

Suggested Citation

Bloomfield, Robert J. and O'Hara, Maureen and Saar, Gideon, How Noise Trading Affects Markets: An Experimental Analysis (May 2007). Available at SSRN: https://ssrn.com/abstract=994379 or http://dx.doi.org/10.2139/ssrn.994379

Robert J. Bloomfield

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

450 Sage Hall
Ithaca, NY 14853
United States
607-255-9407 (Phone)
607-254-4590 (Fax)

Maureen O'Hara

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States
607-255-3645 (Phone)
607-255-5993 (Fax)

Gideon Saar (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

431 Sage Hall
Ithaca, NY 14853
United States
607-255-7484 (Phone)
607-255-5993 (Fax)

HOME PAGE: https://www.johnson.cornell.edu/Faculty-And-Research/Profile?id=gs25

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