The Journal of Financial Research•Vol. XXXI, No. 3•Pages 247–270•Fall 2008INFORMATION AND NOISE IN FINANCIAL MARKETS: EVIDENCEFROM THE E-MINI INDEX FUTURESAlexander KurovWest Virginia UniversityAbstractI examine the informational contributions and effects on transitory volatility oftrades initiated by different types of traders in three actively traded index futuresmarkets. The results show that trades initiated by exchange member firms accountfor more than 60% of price discovery during the trading day. These institutionaltrades appear to be more informative than trades of individual exchange membersor off-exchange traders. I also find that off-exchange traders introduce more noiseinto the prices than do exchange members. My findings provide new evidence onthe role of different types of traders in the price formation process.JEL Classification: G10, G14I. IntroductionI examine the roles of different types of traders in the price discovery processand their effect on transitory volatility in index futures markets. First, I analyzethe relative information content of trades initiated by individual exchange mem-bers, exchange member firms, and off-exchange traders in three E-mini index fu-tures markets. Kurov and Lasser (2004) use Hasbrouck’s (1995) information shareapproach to show that individual exchange members make larger informationalcontributions than off-exchange traders or clearing member firms. Consistent withKurov and Lasser, I find that the informational contributions of off-exchange tradersare relatively small. However, the results also show that exchange member firmscontribute significantly more to price discovery than do individual members or off-exchange traders. Trades of exchange member firms appear to be more informativethan trades of other traders. These results show that institutional traders now playa dominant informational role in electronic index futures markets.I thank Lou Abarcar, Arabinda Basistha, Robert Daigler (the referee), Upinder Dhillon, Grigori Eren-burg, Gerald Gay (the editor), Andrew Harvey, Dennis Lasser, Peter Locke, Stephen Satchell, and RobertWebb for helpful comments and suggestions. Special thanks to Alessio Sancetta for many helpful dis-cussions. I am also grateful to the staff of the Commodity Futures Trading Commission for their help inobtaining the data. Any remaining errors are my own.247248 The Journal of Financial ResearchSecond, I analyze the effect of trading activity initiated by different typesof futures traders on transitory volatility. I find that trades initiated by off-exchangetraders are positively related to transitory volatility, whereas the similar relationfor individual and institutional exchange member trades is negative. This finding,supported by results from a decomposition of transitory volatility, shows that off-exchange traders introduce more noise into the prices than do exchange members.My analysis of transitory volatility extends the work of Daigler and Wiley(1999), who show that the positive volume–volatility relation is determined by off-exchange traders, whereas trading volumes of exchange clearing members tend tohave a negative relation with volatility. They conclude that off-exchange traders aremore likely to trade on noise and cause excess volatility than exchange members,who are more informed. However, when returns are sampled at daily intervals, asin Daigler and Wiley, the estimated volatility may be dominated by informationflow.1Therefore, the results of Daigler and Wiley may be explained by differentialcontributions of trader types to the price discovery process rather than by noisetrading. My results are broadly consistent with theirs but provide direct evidenceon the relation between noise volatility and trading activity classified by trader type.I consider the S&P 500, NASDAQ-100, and Russell 2000 E-mini indexfutures markets for several reasons. First, the trader type classifications availablein futures trade data allow studying the effects of proprietary trading by exchangemember firms. Such institutional traders play an important intermediary role onmany securities exchanges. Second, the E-mini contracts trade on an electronic limitorder market that is similar to the trading systems that now account for most of thesecurities trading around the world. Therefore, my results can be generalized to otherelectronic markets. Finally, an analysis of the E-mini markets allows examining theafter-hours trading period, when the major stock markets are closed.Overall, my findings contribute to a better understanding of the roles ofdifferent types of traders in price formation. I find that off-exchange traders accountfor a disproportional share of noise, whereas institutional traders introduce lessnoise and bring more information to the market. Institutional traders are better ableto exploit their informational advantages in anonymous electronic trading than intraditional floor markets. Therefore, given the continuing transition to electronictrading in the U.S. securities markets, we can expect an increasing informationaldominance of institutions across a variety of markets.1Speight, McMillan, and Ap Gwilym (2000) examine the component structure of volatility in theFTSE 100 index futures market. They show that the transitory component dominates the volatility processover intraday frequencies, whereas the long-run component dominates over daily and lower frequencies.They argue that the long-run volatility component is determined by information flow, and the transitorycomponent may be induced by trading activity.Information and Noise in Financial Markets 249II. Literature ReviewPrice Formation and Noise TradingPrice information is perhaps the single most important product of financial markets.Informative prices reflect the underlying asset values and contribute to efficientallocation of resources in the economy. French and Roll (1986) provide evidence thatprivate information, which is reflected in the prices through the trading of informedtraders, accounts for most of the information affecting stock prices. Security pricescontain information, but they also contain noise induced by market frictions andnoise trading. Grossman and Stiglitz (1980) and Kyle (1985) offer a theoreticalrationale for existence of noise trading by showing that noise is necessary forinformed traders to profit from their information. Noise traders facilitate the price-discovery process by providing camouflage to informed