Price Formation with Autocorrelated Order Flow: Theory and Evidence

Abstract:     
This paper studies the relation between order imbalances and daily returns of individual stocks. Our tests are motivated by a theoretical framework, whose distinguishing feature is that it explicitly considers how market makers with inventory concerns dynamically accommodate autocorrelated imbalances. Persistence in imbalances arises because agents split their orders over time to minimize expected trading costs. In equilibrium, continuing price pressures caused by autocorrelated imbalances cause a positive relation between lagged imbalances and returns over daily horizons. However, this positive relation reverses sign after controlling for the current imbalance. We find empirical evidence consistent with all of these implications of the model. We also find that imbalance-based trading strategies yield statistically significant returns, the magnitude of which is moderate enough to be consistent with an equilibrium wherein intermediaries with inventory concerns accommodate persistent trader demands. Our results shed light on the role of inventory effects in daily stock price movements.

Number of Pages in PDF File: 55

Keywords: Microstructure, Order Imbalance, Individual Stock Returns

JEL Classification: G12, G14

working papers series