Informed Trading, Information Asymmetry and Pricing of Information Risk: Empirical Evidence from the NYSE

Bardong, Florian and Bartram, Söhnke M. and Yadav, Pradeep K. (2005): Informed Trading, Information Asymmetry and Pricing of Information Risk: Empirical Evidence from the NYSE.

Abstract

We analyze commonality in informed trading across stocks, and how informed trading varies with the structural and trading characteristics of a firm. We thereby isolate the residual level of informed trading that is unrelated to commonality, trading characteristics, and structural charac-teristics and analyze this measure with respect to its characteristics and pricing relevance. We find evidence of commonality in informed trading, and a systematic dependence of the level of informed trading on firm characteristics, such as, tick size, the existence of options, and the size of the ownership stake of outside parties. Most importantly, we find that the residual level of in-formed trading is the component of informed trading most strongly related to required returns. This indicates that an important part of the information risk premium is related to the inability to differentiate between price fluctuations that are caused by changes in fundamental value from random price moves.

• Item Type: MPRA Paper
• Language: English
• Keywords: Market microstructure; Common factors; Risk factors; Asymmetric information
• Subjects: G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G10 - General

References

Aboody, David, John Hughes, and Jing Liu, 2005, Earnings quality, insider trading, and costs of capital, Journal of Accounting Research 43, 651-673.

Admati, Anat R., 1984, A Noisy Rational Expectations Equilibrium for Multi-asset Securities Markets, Econometrica 53, 629-658.

Admati, Anat R., and Paul Pfleiderer, 1988, A theory of intraday patterns: Volume and price variability, Review of Financial Studies 1, 3-40.

Admati, Anat R., and Paul Pfleiderer, 2000, Forcing firms to talk: Financial disclosure regulation and externalities, Review of Financial Studies 13, 479-519.

Agmon, Tamir, and Donald R. Lessard, 1997, Investor Recognition of Corporate International Diversification, Journal of Finance 32, 1049-1055.

Akerlof, George A., 1970, The market for “lemons”: Quality uncertainty and market mechanism, The Quarterly Journal of Economics 84, 488-500.

Bessembinder, Hendrik, 2003a, Issues in assessing trade execution costs, Journal of Financial Markets 6, 233-257.

Bessembinder, Hendrik, 2003b, Trade execution costs and market quality after decimalization, Journal of Financial & Quantitative Analysis 38, 747-777.

Bessembinder, Hendrik, and Herbert Kaufman, M., 1997, A cross-exchange comparison of execution costs and information flow for NYSE-listed stocks, Journal of Financial Economics 46, 293-319.

Bhattacharya, Nilabhra, Ervin L. Black, Theodore E. Christensen, and Richard D. Mergenthaler, 2004, Empirical evidence on recent trends in pro forma reporting, Accounting Horizons 18, 27-43.

Bhushan, Ravi, 1989a, Collection of Information about Publicly Traded Firms, Journal of Ac-counting and Economics 11, 183-206.

Bhushan, Ravi, 1989b, Firm Characteristics and Analyst Following, Journal of Accounting and Economics 11, 255-274.

Blair, Bevan J., Ser-Huang Poon, and Stephen J. Taylor, 2001, Forecasting S&P 100 volatility: the incremental information content of implied volatilities and high-frequency index re-turns, Journal of Econometrics 105, 5-26.

Boni, Leslie, and J. Chris Leach, 2002, Supply Contraction and Trading Protocol: An Examination of Recent Changes in the U.S. Treasury Market, Journal of Money, Credit & Banking 34, 740-762.

Brealey, Richard, Hayne E. Leland, and David H. Pyle, 1977, Informational asymmetries, financial structure, and financial intermediation, Journal of Finance 32, 371-387.

Breen, William J., Laurie Simon Hodrick, and Robert A. Korajczyk, 2002, Predicting Equity Liquidity, Management Science 48, 470-483.

Brennan, Michael J., Tarun Chordia, and Avanidhar Subrahmanyam, 1998, Alternative factor specifications, security characteristics, and the cross-section of expected stock returns, Journal of Financial Economics 49, 345-373.

Brennan, Michael J., and Avanidhar Subrahmanyam, 1996, Market microstructure and asset pricing: On the compensation for illiquidity in stock returns, Journal of Financial Economics 41, 441-464.

Bushee, Brian J., and Christopher F. Noe, 2000, Corporate disclosure practices, institutional investors, and stock return volatility, Journal of Accounting Research 38, 171-202.

Cao, Charles, Hyuk Choe, and Frank Hatheway, 1997, Does the Specialist Matter? Differential Execution Costs and Intersecurity Subsidization on the New York Stock Exchange, Journal of Finance 52, 1615-1640.

Chalmers, John M. R. and Gregory B. Kadlec, 1998, An Empirical Examination of the Amor-tized Spread, Journal of Financial Economics 48, 159-188.

Chordia, Tarun, Richard Roll, and Avanidhar Subrahmanyam, 2000, Commonality in liquidity, Journal of Financial Economics 56, 3-28.

Chordia, Tarun, Richard Roll, and Avanidhar Subrahmanyam, 2002, Order imbalance, liquidity, and market returns, Journal of Financial Economics 65, 111-130.

Chordia, Tarun, Richard Roll, and Avanidhar Subrahmanyam, 2005, Evidence on the speed of convergence to market efficiency, Journal of Financial Economics 76, 271-292.

Chordia, Tarun, and Avanidhar Subrahmanyam, 2004, Order imbalance and individual stock re-turns: Theory and evidence, Journal of Financial Economics 72, 485-518.

Cochrane, John H., 2001. Asset Pricing (Princeton University Press, Princeton, NJ). Cotter, Julie, and Scott Richardson, 2002, Reliability of asset revaluations: The impact of appraiser independence, Review of Accounting Studies 7, 435-457.

Dennis, Patrick J., and James P. Weston, 2001, Who’s informed? An analysis of stock ownership and informed trading, Working Paper, Rice University.

Dlugosz, Jennifer, Rüdiger Fahlenbrach, Paul Gompers, and Andrew Metrick, 2006, Large blocks of stock: Prevalence, size, and measurement, Journal of Corporate Finance 12, 594-618.

Easley, David, Robert F. Engle, Maureen O'Hara, and Liuren Wu, 2001, Time varying arrival rates of informed and uninformed trades, Working Paper, Cornell University.

Easley, David, Soeren Hvidkjaer, and Maureen O'Hara, 2002, Is information risk a determinant of asset returns?, Journal of Finance 57, 2185-2221.

Easley, David, Soeren Hvidkjaer, and Maureen O'Hara, 2004, Factoring information into returns, Working Paper, Cornell University.

Easley, David, Nicholas M. Kiefer, and Maureen O'Hara, 1997a, The information content of the trading process, Journal of Empirical Finance 4, 159-186.

Easley, David, Nicholas M. Kiefer, and Maureen O'Hara, 1997b, One day in the life of a very common stock, Review of Financial Studies 10, 805-835.

Easley, David, and Maureen O'Hara, 1987, Price, trade size, and information in securities markets, Journal of Financial Economics 19, 69-90.

Easley, David, and Maureen O'Hara, 1992, Time process of security price adjustment, Journal of Finance 47, 577-605.

Easley, David, and Maureen O'Hara, 2004, Information and the cost of capital, Journal of Finance 59, 1553-1583.

Easley, David, Maureen O'Hara, and P. S. Srinivas, 1998, Option volume and stock prices: Evidence on where informed traders trade, Journal of Finance 53, 431-465.

Ellis, Katrina, Roni Michaely, and Maureen O'Hara, 2000, The Accuracy of Trade Classification Rules: Evidence from Nasdaq, Journal of Financial and Quantitative Analysis 35, 529-551.

Evans, Martin D. D., and Richard K. Lyons, 2004, A New Micro Model of Exchange Rate Dynamics, Working Paper, NBER.

Fama, Eugene F., and Kenneth F. French, 1995, Size and book-to-market factors in earnings and returns, Journal of Finance 50, 131-155.

Fama, Eugene F., and Kenneth R. French, 1992, The Cross-Section of Expected Stock Returns, Journal of Finance 47, 427-465.

Fama, Eugene F., and Kenneth R. French, 1993, Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33, 3-56.

Fama, Eugene F., and Kenneth R. French, 1997, Industry costs of equity, Journal of Financial Economics 43, 153-193.

Fama, Eugene F., and James D. MacBeth, 1973, Risk, Return, and Equilibrium: Empirical Tests, Journal of Political Economy 81, 607-636.

Farrar, Donald E., and Lance Girton, 1981, Institutional Investors and Concentration of Financial Power: Berle and Means Revisited, Journal of Finance 36, 369-381.

Ferson, Wayne E., 2003, Tests of multifactor pricing models, volatility bounds and portfolio performance, Working Paper, NBER.

Ferson, Wayne E., and Campbell R. Harvey, 1999, Conditioning variables and the cross section of stocks returns, Journal of Finance 54, 1325-1360.

Fleming, Michael J., and Eli M. Remolona, 1999, Price formation and liquidity in the U.S. Treasury market: The response to public information, Journal of Finance 54, 1901-1945.

French, Kenneth R., and Richard Roll, 1986, Stock return variances: The arrival of information and the reaction of traders, Journal of Financial Economics 17, 5-26.

Froot, Kenneth A., and Tarun Ramadorai, 2005, Currency Returns, Intrinsic Value, and Institutional-Investor Flows, Journal of Finance 60, 1535-1566.

George, Thomas J., Gautam Kaul, and M. Nimalendran, 1991, Estimation of the bid-ask spread and its components: A new approach, Review of Financial Studies 4, 623-656.

Gilson, Stuart C., Paul M. Healy, Christopher F. Noe, and Krishna G. Palepu, 2001, Analyst Specialization and Conglomerate Stock Breakups, Journal of Accounting Research 39, 565-582.

Glosten, Lawrence R., 1987, Components of the bid-ask spread and the statistical properties of transaction prices, Journal of Finance 42, 1293-1307.

Glosten, Lawrence R., and Paul R. Milgrom, 1985, Bid, ask and transaction prices in a specialist market with heterogeneously informed traders, Journal of Financial Economics 14, 71-100.

Grossman, Sanford J., and Joseph E. Stiglitz, 1980, On the impossibility of informationally effi-cient markets, American Economic Review 70, 393-408.

Habib, Michael A., Johnsen, D. Bruce, and Narayan Y. Naik, 1997, Spinoffs and information, Journal of Financial Intermediation 6, 153-176.

Hansch, Oliver, Narayan Y. Naik, and S. Viswanathan, 1999, Preferencing, internalization, best execution, and dealer profits, Journal of Finance 54, 1799-1828.

Harris, Lawrence, 1990, Statistical properties of the Roll serial covariance bid/ask spread estimator, Journal of Finance 45, 579-590.

Harris, Lawrence, 2003. Trading and Exchanges (Oxford University Press, New York, NY).

Hasbrouck, Joel, 1991, Measuring the information content of stock trades, Journal of Finance 46, 179-207.

Hasbrouck, Joel, and Duane J. Seppi, 2001, Common factors in prices, order flows, and liquidity, Journal of Financial Economics 59, 383-411.

Hasbrouck, Joel, and George Sofianos, 1993, The trades of market makers: An empirical analysis of NYSE specialists, Journal of Finance 48, 1565-1593.

Ho, Thomas, and Hans R. Stoll, 1981, Optimal dealer pricing under transactions and return un-certainty, Journal of Financial Economics 9, 47-73.

Huang, Roger D., and Hans R. Stoll, 1996, Dealer versus auction markets: A paired comparison of execution costs on NASDAQ and the NYSE, Journal of Financial Economics 41, 313-357.

Huang, Roger D., and Hans R. Stoll, 1997, The components of the bid-ask spread: a general approach, Review of Financial Studies 10, 995-1034.

Hughes, John, Jing Liu, and Jun Liu, 2005, Private information, diversification, and asset pricing, Working Paper, University of California in Los Angeles.

Kairys, Jr., Joseph P., Raimonds Kruza, and Ritvars Kumpins, 2000, Winners and losers from the introduction of continuous variable price trading: Evidence from the Riga Stock Ex-change, Journal of Banking & Finance 24, 603-624.

Khandani, Amir E., and Andrew W. Lo, What happened to the Quants in August 2007?, Working Paper, MIT Sloan School of Management.

Kim, Dongcheol, 1995, The errors in the variables problem in the cross-section of expected stock returns, Journal of Finance 50, 1605-1634.

Kim, Oliver, and Robert E. Verrecchia, 1994, Market liquidity and volume around earnings announcements, Journal of Accounting and Economics 17, 41-67.

Kim, Oliver, and Robert E. Verrecchia, 1997, Pre-announcement and Event-period Private In-formation, Journal of Accounting and Economics 24, 395-419.

Kothari, S. P. , Ted E. Laguerre, and Andrew J. Leone, 2002, Capitalization versus expensing: Evidence on the uncertainty of future earnings from capital expenditures versus R&D out-lays, Review of Accounting Studies 7, 355-382.

Kyle, Albert S., 1985, Continuous auctions and insider trading, Econometrica 53, 1315-1335.

Lakonishok, Josef, and Inmoo Lee, 2001, Are insider trades informative?, Review of Financial Studies 14, 79-111.

Lease, Ronald C., Ronald W. Masulis, and John R. Page, 1991, An Investigation of Market Microstructure Impacts on Event Study Returns, Journal of Finance 46, 1523-1536.

Lee, Charles M. C., and Mark J. Ready, 1991, Inferring Trade Direction from Intraday Data, Journal of Finance 46, 733-746.

Lee, Charles M.C., Andrei Shleifer, and Richard H. Thaler, 1991, Investor Sentiment and the Closed-End Fund Puzzle, Journal of Finance 46, 75-109.

Litzenberger, Robert H., and Krishna Ramaswamy, 1979, The effect of personal taxes and divi-dends on capital asset prices: Theory and empirical evidence, Journal of Financial Eco-nomics 7, 163-195.

Llorente, Guillermo, Roni Michaely, Gideon Saar, and Jiang Wang, 2001, Dynamic Volume-Return Relation of Individual Stocks, Review of Financial Studies 15, 1005-10047.

Lyons, Richard K., 2001. The Microstructure Approach to Exchange Rates (The MIT Press, Cambridge, MA).

Madrigal, Vicente, 1996, Non-Fundamental Speculation, Journal of Finance 51, 553-578.

Malkiel, Burton G., and Atanu Saha, 2005, Hedge Funds: Risk and Return, Financial Analyst Journal 61, 80-88.

Matsumoto, Dawn A., 2002, Management's incentives to avoid negative earnings surprises, Ac-counting Review 77, 483-514.

Maug, Ernst, 2002, Insider trading legislation and corporate governance, European Economic Review 46, 1569-1597.

Merton, Robert C., 1987, A simple model of capital market equilibrium with incomplete information, Journal of Finance 42, 483-510.

Naik, Narayan Y., and Pradeep K. Yadav, 2003a, Do dealer firms manage inventory on a stock-by-stock or a portfolio basis?, Journal of Financial Economics 69, 325-353.

Naik, Narayan Y., and Pradeep K. Yadav, 2003b, Trading costs of public investors with obligatory and voluntary market-making: Evidence from market reforms, Working Paper, London Business School.

Neal, Robert, and Simon M. Wheatley, 1998, Adverse selection and bid-ask spreads: Evidence from closed-end funds, Journal of Financial Markets 1, 121-149.

NYSE, 2006, NYSE Regulation: Dealings and Settlements (Rules 45-299C), (New York Stock Exchange: http://rules.nyse.com/nysetools/Exchangeviewer.asp?SelectedNode=chp_1_2&manual=/nyse/nyse_rules/nyse-rules/).

Odders-White, Elizabeth R., and Mark J. Ready, 2006, Credit ratings and stock liquidity, Review of Financial Studies 19, 119-157.

Panayides, Marios, 2004, The Specialist’s Participation in Quoted Prices and the NYSE’s Price Continuity Rule, Working Paper, Yale School of Management.

Potential, Glenn M., and Sridhar Sundaram, 1995, The conditional relation between beta and re-turns, Journal of Financial and Quantitative Analysis 30, 101-116.

Ready, Mark J., 1999, The Specialist’s Discretion: Stopped Orders and Price Improvement, Re-view of Financial Studies 12, 1015-1112.

Roll, Richard, 1984, A simple implicit measure of the effective bid-ask spread in an efficient market, Journal of Finance 39, 1127-1139.

Subrahmanyam, Avanidhar, 1991, A theory of trading in stock index futures, Review of Financial Studies 4, 17-51.

Sydsaeter, Knut, Arne Strøm, and Peter Berck, 2000. Economists’ Mathematical Manual (Springer, Heidelberg).

Vega, Clara, 2006, Stock price reaction to public and private information, Journal of Financial Economics 82, 103-133.

Yan, Xuemin Sterling, and Zhe Zhang, 2007, Institutional Investors and Equity Returns: Are Short-term Institutions Better Informed?, Review of Financial Studies forthcoming.