Off-Exchange Trading and Post Earnings Announcement Drift
57 Pages Posted: 1 Aug 2018 Last revised: 7 Aug 2019
Date Written: June 30, 2019
Off-exchange trading, which tends to attract uninformed trades, accounts for 35 percent of trading volume today. Microstructure theory suggests that taking uninformed trades off exchanges harms liquidity but improves price discovery prior to public information release. We examine how this trade-off affects a longstanding anomaly suggesting investor underreaction: price drifts after earnings announcements. The liquidity (price discovery) channel predicts that off-exchange trading increases (decreases) underreaction. Our results, based on investigation of a large panel of US firms and a natural experiment created by the SEC’s Tick Size Pilot program, suggest the liquidity channel dominates. The negative effects of off-exchange trading on liquidity (less depth and wider spreads) likely increase arbitrage costs, thereby increasing residual underreaction. We find that the positive relation between off-exchange trading and underreaction remains strong even after we control for a host of observable arbitrage cost measures. Levels of off-exchange trading proxy well for hard-to-measure arbitrage costs.
Keywords: Off-exchange trading; Post-earnings-announcement-drift; Limits to arbitrage; Liquidity; Price discovery; Price efficiency
JEL Classification: G12; G14
Suggested Citation: Suggested Citation