Noisy prices result when the demands of impatient uninformed traders cause prices to diverge from fundamental values. These price changes are temporary, because prices eventually revert to fundamental values. Transitory volatility includes both the price changes caused by impatient, uninformed traders and the subsequent reversals of those price changes. Liquidity suppliers do not cause transitory volatility, but they do contribute to its ultimate resolution.
Example 1: Bid-Ask Bounce Effect
Bid/ask bounce is the simplest form of transitory volatility. It occurs when traders buy at ask prices and sell at bid prices. Their trades cause prices to bounce from bid to ask. These price changes reverse when traders arrive on the other side of the market.
Example 2: Rounding Effect
Financial prices are often discretized – to the nearest cent, for example. Thus we can say prices are observed with rounding error. A simple example is the rounding of price to the nearest cent (deterministic rounding) or the situation where the next trade is made with probability 1/2 on the closest bid- and with probability 1/2 on the closest ask-level of an order book (stochastic rounding).