Why Liquidity and Noise Trading Can Distort Market Prices
Summary
The document discusses what can make market prices temporarily differ from fundamental value, in the context of market resiliency. It identifies several microstructure mechanisms: asymmetric information, market makers’ inventory risk, trading costs, and search frictions. It also points to less information-driven trading, where participants’ liquidity decisions can move prices without being based on fundamentals.
Potential sources of such behavior include political constraints such as currency pegs, stale information, and differences in trading costs. These mechanisms help explain why an observed price distortion need not be a fat-finger trade or flash crash; it can arise from ordinary trading incentives and limits on liquidity. The answers are brief and offer no quantitative model or method for identifying an incorrect price in real time. They frame the topic as an introduction to market microstructure and noise-trader theory, rather than a precise definition of fair value or a guarantee that prices will quickly revert.
Key ideas
- Information asymmetry can cause prices to reflect adverse-selection risk faced by liquidity providers.
- Market makers’ inventory risk can affect the prices at which they are willing to trade.
- Trading costs and search frictions can distort prices even without an obvious market failure.
- Noise traders and stale information can push prices away from fundamental assessments.
- Political constraints and uneven trading costs can also contribute to temporary price distortions.
Tags
Full text
# What are the causes of incorrect prices in the market? # What are the causes of incorrect prices in the market? If market resiliency, a measure of liquidity, is the amount of time it takes a market to bounce back from temporarily incorrect prices, then what makes a price "incorrect"? Is this like fat-finger trades and flash crashes ? ## Answer by Malick (score 1) https://quant.stackexchange.com/a/21296 Genereally speaking main identifed liquidity costs (or prices distortion - see Amihud, Y., Mendelson, H., Heje Pedersen, L., 2005. Liquidity and Asset Prices) are related to the asymmetric information theory, the inventory risk paradigm for market makers, trading costs and search problems. All that topics are studied in the Market Microstructure theory. A good starting point to know more about it is the following article : Madhavan, A., 2000. Market microstructure: A survey. Journal of Financial Market. ## Answer by madilyn (score 1) https://quant.stackexchange.com/a/21298 In addition to Malick's paper, I believe Shleifer and Summers (1990), The Noise Trader Approach to Finance should answer your question. Some market participants are not fully 'rational' and their decisions to take or provide liquidity are not driven by fundamental pricing information, leading to 'inefficient' or 'irrational' prices. This irrationality can be attributed to a variety of reasons - political (e.g. currency pegs), asymmetric information (traders acting on stale data), non-uniform trading costs etc. The idea that liquidity is limited and therefore can be distorted by noise traders isn't something new, as reflected by Keynes's often-cited statement: "The market can stay irrational longer than you can stay solvent."
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.