Econ 138: Financial and Behavioral Economics

Noise

February 6, 2017

Reading:
F. Black, “Noise,” Journal of Finance, XLI, 529–541 (1986).
M. Granovetter, “The Impact of Social Structure on Economic
Outcomes,” (2005), pp. 40–41.
N. Barberis and R. Thaler, “A Survey of Behavioral Finance,” (2003).

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 1/ 29

Noise

If the reader interjects that there must surely be large

profits to be gained . . . in the long run by a skilled
individual who . . . purchase[s] investments on the best
genuine long-term expectation he can frame, he must be
answered . . . that there are such serious-minded
individuals and that it makes a vast difference to an
investment market whether or not they predominate.
. . . But we must also add that there are several factors
which jeopardize the predominance of such individuals in
modern investment markets. Investment based on
genuine long-term expectation is so difficult . . . as to be
scarcely practicable. He who attempts it must surely
. . . run greater risks than he who tries to guess better
than the crowd how the crowd will behave.
— J.M. Keynes (1936)

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 2/ 29

Noise

Agenda:
1 Black on noise: finance, econometrics, & macro.
2 Shiller on noise: price volatility.
3 Baker on noise: volatility in the CBOE pits.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 3/ 29

Black on Noise

Fisher Black’s sense of noise:

Noise is defined in contrast to information.

Some trade on information, others on noise.

Noise trading should not be profitable.

Noise trading is required for a liquid market.

“If my conclusions are not accepted, I will blame it on noise.”

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 4/ 29

Black on Noise
Noise obscures: observations are imperfect.

0.05 dx
= a(x, t) + b(x, t)η(t)
dt
PROBABILITY

0.04 | {z }
noise
0.03
0.02
0.01 200
0 150
0 100
0.2
0.4 50 SPY (USD)
0.6
0.8 0
TIME (years) 1

∂P(x, t|x0 , t0 ) ∂ h i
=− a(x, t)P(x, t|x0 , t0 )
∂t ∂x
1 ∂2 h 2
i
+ b(x, t) P(x, t|x0 , t0 )
2 ∂x 2
Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 5/ 29
Black on Noise

Finance:
Without noise, very little trading.

When information dominates it can reduce trading.

Noise is different from differences in information.

Noise trading is trading on noise as if it were information.

Noise (information) traders generally lose (make) money.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 6/ 29

Black on Noise

Finance:
More trading improves market liquidity.

But noise trading generates more noise.

Price discovery necessarily reflects both information and noise.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 7/ 29

Black on Noise

Finance:
Information trading cannot eliminate noise trading.

Regardless of the perceived edge, a larger position entails

larger risk.

You never really know if you are trading on information or

trading on noise.

It is difficult to separate skill from luck.

Who is an information trader? Who is a noise trader?

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 8/ 29

Black on Noise

Econometrics:
Why do people trade on noise?

Can trading enter the utility function?

Can dividends enter the utility function?

“The idea that dividends convey information beyond that conveyed

by the firm’s financial statements and public announcements
stretches the imagination.”

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 9/ 29

Black on Noise

In the end, a theory is accepted not because it is

confirmed by conventional empirical tests, but because
researchers persuade one another that the theory is
correct and relevant.
— Fisher Black

A new scientific truth does not triumph by convincing its

opponents and making them see the light, but rather
because its opponents eventually die, and a new
generation grows up that is familiar with it.
— Max Planck

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 10/ 29
Shiller on Noise
R.J. Shiller, “Do Stock Prices Move Too Much . . . ,” (1981)

The first paper to discuss “what had to that time been an oral
tradition.” — L. Summers

An important challenge to the EMH:

A stock price is the present value of the expected dividends.

Rationally, fluctuations in the price of a stock should follow

from fluctuations in dividends and/or the discount factors
(rates).

We can calculate the ex-post rational price for stock indices.

Let’s compare them to the actual time series.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 11/ 29
Shiller on Noise
R.J. Shiller, “Do Stock Prices Move Too Much . . . ,” (1981)

An important challenge to the EMH:

The actual price pt is related to the rational price pt∗ by

ut = pt∗ − pt

where ut is the forecast error, or pt∗ = pt + ut .

Since the forecast error must be uncorrelated with the forecast

(σpt ,ut = 0), it follows that

σp2∗ = σp2 + σu2

from which
σp2 ≤ σp2∗ or σp ≤ σp∗

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 12/ 29
Shiller on Noise
R.J. Shiller, “Do Stock Prices Move Too Much . . . ,” (1981)

An important challenge to the EMH: is σp ≤ σp∗ ?

422 THE AMERICAN ECONOMIC REVIEW JUNE 1981

Index
300- Index
2000-

225!
1500
p

150- *
1000-

75-
500-

0 I year yeor
0 I I I I 1
1870 1890 1910 1930 1950 1970 1928 1938 1948 1958 1968 1978

FIGURE 1 FIGURE 2
Note: Real Standardand Poor'sCompositeStock Price Note:RealmodifiedDow JonesIndustrialAverage(solid
Index (solid line p) and ex post rationalprice (dotted line p) and ex post rational price (dotted line p*),
line p*), 1871- 1979,both detrendedby dividinga long- 1928-1979,both detrendedby dividingby a long-run
run exponentialgrowth factor. The variablep* is the exponentialgrowthfactor.Thevariablep* is the present
“This inequality . . . is dramatically violated in [these Figures and] is
present value of actual subsequentreal detrendeddi- value of actual subsequentreal detrendeddividends,
vidends, subject to an assumptionabout the present subject to an assumptionabout the present value in
immediately obvious by looking at the figures.” — R. Shiller 1981
value in 1979 of dividendsthereafter.Data are from 1979of dividendsthereafter.Data are from Data Set 2,
Data Set 1, Appendix. Appendix.
Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 13/ 29
Shiller on Noise
R.J. Shiller, “Do Stock Prices Move Too Much . . . ,” (1981)

An important challenge to the EMH: Summary.

Measures of stock price volatility appear far to high.

5 to 15 times too high to be attributed to new information
about real dividends.

Changes in (unobservable) real rates needed to match

volatility are too large.
What about uncertainty regarding future dividends?
Uncertainty would need to exceed by many times the
movements in real dividends observed in the Great Depression.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 14/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 15/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Price Discovery and Market Size

The market is one of the preeminent institutions of modern

capitalist societies.

Baker conceptualized the structure of the stock options

market as a social network of buyers and sellers.

Contrary to the expectations of conventional economic and

financial research, this market exhibited discernible social
structural patterns with demonstrable effects on the
determination of prices.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 16/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Price Discovery and Market Size

In the ideal-typical model of the market, actors are assumed

to be hyper-rational; each actor is a self-interested maximizer
endowed with unlimited information-processing and analytical
faculties.
Market actors are more realistically described by two
behavioral assumptions:
1 Human agents are subject to bounded rationality.
2 At least some agents are given to opportunism.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 17/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

About bounded rationality and opportunism:

Bounded rationality emphasizes the inherent limitations of

human cognitive powers and capacities to transmit and
assimilate information, analyze data, and make decisions
under the conditions of complexity and uncertainty.

Opportunism refers to the observation that some actors are

not entirely trustworthy and honest; in any given economic
situation, at least some actors will take advantage of others.

The purely self-interested maximizer, in contrast, is presumed

to be trustworthy and to follow and abide by the rules of the
game.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 18/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Life in the pit:

Floor participants (brokers and market makers,) are acutely

aware of their limitations in receiving, processing, and
responding to market information.

Noise and the physical separation of potential trading partners

are often cited as major impediments to the efficient
communication of offers to buy and sell.

In an active and fast-moving market, a floor participant is not

able to survey fully all potential partners to a trade.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 19/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Life in the pit:

Searching for all the alternatives is a costly process.

A broker cannot take the time fully to search the “other side”
of the market to obtain the best possible price for a customer.

Executing an order, therefore, invokes satisficinga rather than

maximizing behavior.

a
Satisficing: taking the first good response to an offer.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 20/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Uncertainty in the market:

Although trading can be lucrative, there is no guarantee of

profits.

In 1977, fully 40% of the 1,153 registered broker-dealers who

reported market-making activities on national securities
Exchanges reported losses.

The volatility of prices itself is a major source of uncertainty.

To cope with the uncertainty engendered by price volatility,

actors must limit or restrain their trading, and some actors
will act opportunistically.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 21/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Stock price volatility and crowd size:

A large crowd presents many more potential relationships to

market actors than a small crowd.

If rationality were not bounded, an actor in a large crowd

would be able to take advantage of the many trading
relationships available.

But numerous actors generate a great deal of noise which

interferes with communication.

The physical dimensions of a crowd made up of many actors

increase the distances between all potential trading partners.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 22/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Networks within crowds:

In an ideal-typical market, actors would not be limited in their
ability to communicate with all other actors and to search the
”other side” fully in order to find the best price.

Under the assumptions of bounded rationality & opportunism,

actors are compelled to limit and restrict their trading.

Participants’ limited information-reception and

information-processing abilities force them to restrict their
search for partners to a trade.

“Noise, static. The errors increase as an inverse square of the

distance between brokers. . . . You trade with people in close
proximity to reduce the risk; there’s money at risk.” — A Trader
Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 23/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Price consequences:

“In the really large crowds that are really active, it’s possible to get
trading in very different prices. [Why?] It’s noisy; you can’t hear.
It happens when the stock is changing. Some people trade, and
they tell others, and then lots of people are coming over. There are
some aberrations sometimes.”
— A Veteran Market Maker

Past a certain point, crowd size induces the formation of

multiple cliques.

Large size (and growth) is the main cause of heightened price

volatility.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 24/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Research Approach:

Participant observation and informal interviewing.

Network analysis of trades.

Trade data supplied by the Exchange.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 25/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 26/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 27/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Microeconomic expectations not supported by this work:

ABC market should be more competitive than XYZ market

since a larger number of competitors (participants) trade in
ABC marketplace.

A market becomes more competitive, and hence less

differentiated, as the number of actors increases.

There is no rationale for trading in subgroups in a competitive

market.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 28/ 29
Baker on Noise
W.E. Baker, “The Social Structure of a National Securities Market” (1984)

Implications:

Price volatility is used by investors as an important indicator

of the risk of holding a security and of the intrinsic value of
the assets represented by a security.

Every corporation watches the volatility of the price of its

securities in order to decide if and when to issue new
securities.

Empirical networks substantially influence option price

volatility.

These subgroups are truly emergent – they are the unintended

outcomes of human limitations on trading in the context of
large aggregates.

Lecture 6 – Noise: R. J. Hawkins Econ 138: Financial and Behavioral Economics 29/ 29