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Noise Trading and the Management of Operational Risk; Firms, Traders and Irrationality in Financial Markets

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  • Paul Willman
  • Mark Fenton‐O'Creevy
  • Nigel Nicholson
  • Emma Soane

Abstract

abstract Efficient market models cannot explain the high level of trading in financial markets in terms of asset portfolio adjustment. It is presumed that much of this excessive trading is irrational ‘noise’ trading. A corollary is that there must either be irrational traders in the market or rational traders with irrational aberrations. The paper reviews the various attempts to explain noise trading in the finance literature, concluding that the persistence of irrationality is not well explained. Data from a study of 118 traders in four large investment banks are presented to advance reasons why traders might seek to trade more frequently than financial models predict. The argument is advanced that trades do not simply occur in order to generate profit, but it does not follow that such trading is irrational. Trading may generate information, accelerate learning, create commitments and enhance social capital, all of which sustain traders' long term survival in the market. The paper treats noise trading as a form of operational risk facing firms operating in financial markets and discusses approaches to the management of such risk.

Suggested Citation

  • Paul Willman & Mark Fenton‐O'Creevy & Nigel Nicholson & Emma Soane, 2006. "Noise Trading and the Management of Operational Risk; Firms, Traders and Irrationality in Financial Markets," Journal of Management Studies, Wiley Blackwell, vol. 43(6), pages 1357-1374, September.
    • Handle: RePEc:bla:jomstd:v:43:y:2006:i:6:p:1357-1374
    DOI: 10.1111/j.1467-6486.2006.00648.x
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    References listed on IDEAS

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    1. James J. Choi & David Laibson & Andrew Metrick, "undated". "Does the Internet Increase Trading? Evidence from Investor Behavior in 401(K) Plans," Rodney L. White Center for Financial Research Working Papers 15-00, Wharton School Rodney L. White Center for Financial Research.
    2. Power, Michael, 2003. "The invention of operational risk," LSE Research Online Documents on Economics 21368, London School of Economics and Political Science, LSE Library.
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