Predictability of Order Imbalance, Market Quality and Equity Cost of Capital

72 Pages Posted: 20 Dec 2018 Last revised: 26 Dec 2019

See all articles by Daniele Bianchi

Daniele Bianchi

School of Economics and Finance, Queen Mary University of London

Matthias Büchner

University of Warwick - Finance Group

Roman Kozhan

University of Warwick - Warwick Business School

Date Written: March 15, 2019

Abstract

We study the effect of the predictability of order imbalance on market quality. We measure the degree of predictability by using the predictive likelihood from a dynamic linear model where the dependent variable is the day-ahead order imbalance. Empirically, we show that increasing order imbalance predictability corresponds to significantly higher market liquidity and efficiency. This positive relationship is economically significant: a long-short portfolio based on past predictability generates significant risk-adjusted returns. Predictability of order imbalance measures a cost of asymmetric information that is not captured by traditional measures of adverse selection. The risk factor that is associated with asymmetric information is priced in the cross-section of stock returns, controlling for a variety of conventional sources of systematic risk. These results suggest the existence of a tight link between market microstructure features affecting order imbalance predictability and both market quality and the cost of capital of firms.

Keywords: Order Imbalance Predictability, Market Efficiency, Liquidity Provision, Asymmetric Information

JEL Classification: G10, G11, G14, G17

Suggested Citation

Bianchi, Daniele and Büchner, Matthias and Kozhan, Roman, Predictability of Order Imbalance, Market Quality and Equity Cost of Capital (March 15, 2019). WBS Finance Group Research Paper No. 262. Available at SSRN: https://ssrn.com/abstract=3297233 or http://dx.doi.org/10.2139/ssrn.3297233

Daniele Bianchi (Contact Author)

School of Economics and Finance, Queen Mary University of London ( email )

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United Kingdom

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Matthias Büchner

University of Warwick - Finance Group ( email )

Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain

HOME PAGE: http://mbuechner.com

Roman Kozhan

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

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