May 6, 2019, 12:30–14:00
Room MF 323
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.