Is Information Risk Priced? Evidence from the Price Discovery of Large Trades

Abstract:     
We develop an information risk measure that is based on the price discovery of large trades. As the price series of large trades and small trades are co-integrated, the price discovery of trades can be easily estimated via the vector error-correction model (VECM). Intuitively, we use VECM to study how a temporary gap between the large trade price and small trade price of the same stock is to be closed. If closing the gap is mostly done through small trade price with little movement in large trade price, then it means large trade price has been closer to the long-run equilibrium price, hence that the large trade price has a greater price discovery function for this particular stock. An important feature of our measure, inherent in its construction, is that a higher information risk necessarily means a lower illiquidity. This feature helps disentangle the pricing impact of information risk from that of illiquidity—a major advantage over other information risk measures such as PIN in the information risk pricing tests. We show that our information risk measure performs better than PIN in predicting stock returns and that its predicting power is not affected by various controls of illiquidity, suggesting that information risk is priced and is priced beyond the effect of illiquidity.

Number of Pages in PDF File: 66

Keywords: Information risk, Price discovery, Trade size

JEL Classification: D82, G14

working papers series