Price Formation with Autocorrelated Order Flow: Theory and Evidence

55 Pages Posted: 25 Oct 2002

See all articles by Tarun Chordia

Tarun Chordia

Emory University - Department of Finance

Avanidhar Subrahmanyam

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

Date Written: October 6, 2002

Abstract

This paper studies the relation between order imbalances and daily returns of individual stocks. Our tests are motivated by a theoretical framework, whose distinguishing feature is that it explicitly considers how market makers with inventory concerns dynamically accommodate autocorrelated imbalances. Persistence in imbalances arises because agents split their orders over time to minimize expected trading costs. In equilibrium, continuing price pressures caused by autocorrelated imbalances cause a positive relation between lagged imbalances and returns over daily horizons. However, this positive relation reverses sign after controlling for the current imbalance. We find empirical evidence consistent with all of these implications of the model. We also find that imbalance-based trading strategies yield statistically significant returns, the magnitude of which is moderate enough to be consistent with an equilibrium wherein intermediaries with inventory concerns accommodate persistent trader demands. Our results shed light on the role of inventory effects in daily stock price movements.

Keywords: Microstructure, Order Imbalance, Individual Stock Returns

JEL Classification: G12, G14

Suggested Citation

Chordia, Tarun and Subrahmanyam, Avanidhar, Price Formation with Autocorrelated Order Flow: Theory and Evidence (October 6, 2002). Available at SSRN: https://ssrn.com/abstract=336060 or http://dx.doi.org/10.2139/ssrn.336060

Tarun Chordia (Contact Author)

Emory University - Department of Finance ( email )

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

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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