Liquidity, Volume, and Order Imbalance Volatility

Abstract

We examine the dynamics of liquidity using a comprehensive sample of U.S. stocks in the post-decimalization period. Motivated by a continuous-time inventory model, we compute a high-frequency measure of order imbalance volatility to proxy for the inventory risk faced by liquidity providers. We show that high-frequency order imbalance volatility is an important driver of liquidity and explains the often positive time-series relation between spread and volume for large stocks, which seems to run counter most theoretical models. Furthermore, order imbalance volatility is priced in the cross-section of stock returns.

Keywords: liquidity, volume, volatility, order imbalance, inventory risk, adverse selection

JEL Classification: G10, G12, G14