Academic journal article Academy of Accounting and Financial Studies Journal

Market Noise, Investor Sentiment, and Institutional Investors in the ADR Market

Academic journal article Academy of Accounting and Financial Studies Journal

Market Noise, Investor Sentiment, and Institutional Investors in the ADR Market

Article excerpt

ABSTRACT

This study examines the effects of market noise in the ADR market. We find ADR return affected by noise trader risk and increases (decreases) when investors are irrationally optimistic (pessimistic). Our results also suggest institutional investors have engaged in stealth trading to exploit their information advantage in the noisy ADR market. Through a Granger causality regression, we find the returns on ADR portfolios with high institutional ownership lead the returns of those with low institutional ownership in the low-noise period, confirming that institutional trades reflect market information that is ultimately incorporated into other securities. Finally, we find institutional investors help reduce volatilities of European ADRs. However, for ADRs of Asian and South American firms, magnitude of the stabilizing arbitrage positions taken by rational investors is insignificant.

INTRODUCTION

Fischer Black (1986) suggests that noise is as influential as information in financial markets. Investors who trade on noise are willing to trade even though it is better for them not to trade. They do so because they think the noise on which they base their trading is information.

From existing literature, we can identify three possible effects of noise on securities trading. First, market noise leads to the existence of noise trader risk. De Long et al. (1990) develop a noise trader risk model which argues that when investment decisions are made based on market noise, the decisions are irrational and unpredictable because they are led by investor sentiment in general. Hence, noise traders become a source of risk in the finanical markets. Second, the existence of noise in capital markets provides an opportunity for informed institutional investors to exploit their information advantage. Barclay and Warner (1993) show that informed institutional investors are more likely to engage in "stealth trading" strategies in which the institutions spread their trades gradually over time. Third, the irrational behavior of noise traders in a noisy market may cause asset prices to move away from their fundamental values and destabilize the market. On the other hand, rational institutional investors would take positions opposite to those of the noise traders and help stabilize the market despite De Long et al. (1990) predict that institutional investors would fail to totally encounter the irrational activities of noise traders.

We examine the three possible effects of noise in the ADR market. Our results show that ADR return is affected by investor sentiment in the ADR market. ADR return increases (decreases) when investors are irrationally optimistic (pessimistic). We also find that in the lownoise period, ADRs with high institutional ownership exhibit autocorrelation similar to ADRs with low institutional ownership. However, in the high-noise period, ADRs with high institutional ownership exhibit significant higher autocorrelation than ADRs with low institutional ownership. The result implies institutional investors may have engaged in stealth trading to expolit a noisy market. Through a Granger causality regression, we find returns on ADR portfolios with high institutional ownership lead the returns of those with low institutional ownership in the low-noise period, confirming that institutional trades reflect market information that is ultimately incorporated into other securities. Finally, we find that institutional investors help reduce volatility of European ADR returns. However, for ADRs of Asian and South American firms, the magnitude of the stabilizing arbitrage positions taken by institutional investors is insignificant.

LITERATURE AND MOTIVATION

Financial economists have hypothesized the existence of noise trading in stock markets (for example, Black (1986), Trueman (1988), De Long et al. (1989), (1990), Palomino (1996)). While Black (1986) does not give a reason why investors would rationally want to engage in noise trading, he asserts that it must account for an important fraction of total trading in securities markets. …

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