Liquidity Dynamics and Cross-Autocorrelations

50 Pages Posted: 24 Sep 2007 Last revised: 18 Feb 2011

Tarun Chordia

Emory University - Department of Finance

Asani Sarkar

Federal Reserve Bank of New York

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Date Written: January 27, 2010

Abstract

This paper examines the mechanism by which the incorporation of information into prices leads to cross-autocorrelations in stock returns. We present a simple model where trading on private information occurs first in the large stocks and is transmitted to small stocks with a lag. Such trading impacts large stock liquidity, so that, in equilibrium, large stock illiquidity portends stronger cross-autocorrelations. Empirically, we find that the lead-lag relation between large and small stocks increases with lagged illiquidity indicators of large stocks. Further, order flows in large stocks significantly predict returns of small stocks when large stock spreads are high, at both the market and industry levels. In addition, the role of order flow and liquidity in predicting small stock returns is stronger prior to macro announcements (when information-based trading is more likely).

Keywords: lead-lag, returns, small stocks, large stocks, microstructure, information

JEL Classification: G10, G14

Suggested Citation

Chordia, Tarun and Sarkar, Asani and Subrahmanyam, Avanidhar, Liquidity Dynamics and Cross-Autocorrelations (January 27, 2010). FRB of New York Staff Report No. 303. Available at SSRN: https://ssrn.com/abstract=1016117 or http://dx.doi.org/10.2139/ssrn.1016117

Tarun Chordia

Emory University - Department of Finance ( email )

Atlanta, GA 30322-2710
United States
404-727-1620 (Phone)
404-727-5238 (Fax)

Asani Sarkar (Contact Author)

Federal Reserve Bank of New York ( email )

Research Department
33 Liberty Street
New York, NY 10045
United States
212-720-8943 (Phone)
212-720-1582 (Fax)

HOME PAGE: http://www.newyorkfed.org/research/economists/sarkar/pub.html

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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