# When noise trading fades, volatility rises

## Abstract

We hypothesize and test an inverse relation between liquidity and price volatility derived from microstructure theory. Two important facets of liquidity trading are examined: volume and noisiness. As represented by the expected turnover rate (volume) and realized average commission cost per share (noisiness) of NYSE equity trading, both facets are found negatively associated with the *ex post* and *ex ante* return volatilities of the NYSE stock portfolios and the NYSE composite index futures. Furthermore, the inverse association between noisiness and volatility is amplified in times of market crisis. The negative noisiness–volatility relation is also supported by our analysis on the effects of trade size on price volatility. The overall results demonstrate that volatility increases as noise trading declines.

## Keywords

Noise trading Liquidity Volatility Volume Trade size## JEL Classification

G10 G14## Notes

### Acknowledgments

The author wishes to thank C.F. Lee (Editor) and two anonymous referees for helpful comments, M. Nimalendran, Jeffrey Pontiff, and Jiang Wang for helpful discussions, and Charles Bartlett from SIFMA for providing and explaining part of the data. The financial support from National Science Foundation of China for research project#71,273,150 is gratefully acknowledged.

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