Price Discovery Function of Large Trades and the Cross-Section of Expected Stock Returns
64 Pages Posted: 7 Oct 2010 Last revised: 21 Sep 2011
Date Written: September 18, 2011
The price discovery function measures the private information revealed in prices through trades. As informed traders prefer large trades, the price discovery function of large trades (VECIN), estimated from a vector error correction model of cointegrated price series of large and small trades, measures the extent of information asymmetry between traders. VECIN has a strong impact on future stock returns, and its power to predict stock returns is stronger than any of the well-known return predictors we have considered. A VECIN spread portfolio of NYSE/Amex stocks that goes long in the top VECIN quintile and short in the bottom VECIN quintile earns a Fama-French (1993) risk-adjusted return of 0.99% per month. Adding the VECIN spread portfolio to the Fama-French three factors triples the Sharpe ratio of the ex-post tangency portfolio from 0.24 to 0.71. Further tests suggest that mispricing cannot fully explain the strong pricing impact of VECIN.
Keywords: Price Discovery, Information Risk, Large Trade, VECM
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