Does Noise Trading Affect Securities Market Efficiency?

I investigate the impact of noise trading on securities market efficiency using data from short-horizon Arrow-Debreu securities traded on an online exchange. Using liquidity as a proxy for the amount of noise trading, I show that securities markets with persistently high noise trade exhibit significant pricing anomalies, such as overpricing low probability events and underpricing high probability events. By contrast, markets are remarkably efficient when there is low noise trade or when it is likely that securities’ payoffs will be equal to their fundamental values. These findings are consistent with theoretical models in which rational agents face limits to arbitrage, but inconsistent with frictionless models in which increases in noise trading have no impact or a favorable impact on efficiency. * Please send all comments to [email protected]. The author is in the Department of Finance at the University of Texas at Austin, McCombs School of Business. I would like to thank Robert Hahn, Terry Murray, Chris Parsons, Sheridan Titman, and Eric Zitzewitz for helpful comments.