Order Flow Volatility and Equity Costs of Capital

We propose that the volatility of order flow is a proxy for costs of information asymmetry, as order flow volatility varies positively with parameters that also influence adverse selection costs of trading. Empirically, order flow volatility is significantly higher prior to earnings or merger announ...

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Bibliographic Details
Published inManagement science Vol. 65; no. 4; pp. 1520 - 1551
Main Authors Chordia, Tarun, Hu, Jianfeng, Subrahmanyam, Avanidhar, Tong, Qing
Format Journal Article
LanguageEnglish
Published Linthicum INFORMS 01.04.2019
Institute for Operations Research and the Management Sciences
Subjects
Analysis
asset pricing
Asymmetric information
Capital movement
Cost analysis
Cost of capital
Earnings
Equity (Finance)
Imbalance
investment
order flow
Prices
Rates of return
Securities markets
Stock prices
Trading
Volatility
Volatility (Finance)
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Summary:We propose that the volatility of order flow is a proxy for costs of information asymmetry, as order flow volatility varies positively with parameters that also influence adverse selection costs of trading. Empirically, order flow volatility is significantly higher prior to earnings or merger announcements when information asymmetry is likely to be elevated. Levels of and shocks to order flow volatility are positively and significantly correlated with existing illiquidity proxies, and strongly predict stock returns in the cross section. The impact of order imbalance volatility shocks on stock prices is reflected within one month in large, visible stocks but takes up to four months to be fully reflected in small, “neglected” stocks. The Internet appendix is available at https://doi.org/10.1287/mnsc.2017.2848 . This paper was accepted by Gustavo Manso, finance.
ISSN:0025-1909
1526-5501
DOI:10.1287/mnsc.2017.2848