Skip to main content
SpringerLink
Log in

Informed trade and idiosyncratic return variation

  • Original Research
  • Published:
Review of Quantitative Finance and Accounting Aims and scope Submit manuscript

Abstract

This paper explores the role of private information on idiosyncratic return variation. We suggest that there is a significant positive relationship between informed trade and firm-specific return variation. Using the probability of information-based trading (PIN) as a measure of informed trade, we find that the PIN is positively related to idiosyncratic return variation in both the level and the first-difference. The results imply that firm-specific return variation is induced by informed trade through information flow on price formation. Especially, we find a strong interaction effect between informed trade and trading volume. The impact of informed trade on firm-specific return variation is more profound for stocks with a high trading volume than for stocks with a low trading volume. The result suggests that trading activity plays an important role in the information revelation. The results of various robustness checks confirm that informed trade is an important determinant of idiosyncratic return variation.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

Notes

  1. Note that while private information is revealed through trade, firm-specific public information is reflected in the price formation process of market makers without trade. See O’Hara (1995) for the microstructure theory of the information-trade relationship and Easley and O’Hara (2003) for the literature review on the relation between microstructure and asset pricing.

  2. Recent literature addresses the firm’s information environment (disclosure policy, analyst following, insiders, and institutional investors) or institutional environment (property rights protection, quality of government, and legal origin) which can affect firm-specific return variation. See, Piotroski and Roulstone (2004), Barberis et al. (2005), Jin and Myers (2006), Cahan et al. (2009), Brockman and Yan (2009), Dasgupta et al. (2010), Anandarajan et al. (2011), Luo et al. (2013).

  3. Interestingly, Kelly (2005) examines whether R-square is a reverse measure for price informativeness by comparing R-square with information events, not informed trade. He is silent, however, about informed trade.

  4. The liquidity literature argues that illiquid stocks are more vulnerable to a trade shock, implying more significant price changes for stocks with low trading volumes. Thus, our result contradicts the liquidity interpretation for trade volume but supports the information revelation role of volume. See, Chorida and Swaminathan (2000), Gervais et al. (2001), Kryzanowski and Lazrak (2011), Wang et al. (2012), Ascioglu et al. (2012).

  5. Avramov et al. (2006) also use this model to estimate return variation. Schwert (1990) uses a similar model.

  6. Among others, see French and Roll (1986), Karpoff (1987), Roll (1988), Gallant et al. (1992), and Foster and Viswanathan (1995).

  7. Recently, Hu and Liu (2013) show that there is no significant difference in information content among stocks with high and low R 2 in the Chinese equity market.

  8. Many studies have proposed the improved estimation methods of PIN. These studies involve in developing an algorithm to resolve the issue of boundary solutions, proposing dynamic microstructure models to capture the autoregressive component of PIN, or identifying factors to lead to an econometric bias in estimating PIN. See, Chung et al. (2006), Easley et al. (2008), Brockman and Chung (2008), Tay et al. (2009), Lin and Ke (2011), Yan and Zhang (2012), Akay et al. (2012), Kumar and Popescu (2013), and Hwang et al. (2013).

  9. Since R-square is bounded between zero and one, we construct the LRSQ as a logistic transformation of the R-square. Bharath et al. (2009), Chen et al. (2007), Durnev et al. (2003, 2004), also use a reciprocal of the LRSQ as a proxy for stock price synchronicity or a reverse measure for price informativeness.

  10. Andersen (1996) and Suominen (2001) also use a similar framework to the one suggested by Easley et al. (1997) to explain the trade-return variation relation.

  11. Although the turnover-increase portfolio shows a slightly different pattern, we still find a significant differential change in LRSQ across the two PIN portfolios.

  12. Note that this phenomenon is independent of the return-volatility relation.

  13. Note that we run both the augmented market model and the original market model to obtain the two LRSQ measures.

  14. Recently, Hasbrouck (2009) finds that the Amihud (2002) illiquidity measure is a robust measure of the price impact (λ) proposed by Kyle (1985).

  15. The results on the level analysis are similar to those from the difference analysis. To save space, we report the results of the difference analysis, which is more rigorous than the level analysis.

  16. We have examined the feedback effect for the level of variables. The results show that, while there is no feedback effect from the three RMSEs to PIN, there is a significant positive feedback effect from the two LRSQs to PIN. The coefficients are 0.003 (t-value: 4.93) for LRSQ1 and 0.002 (t-value: 5.25) for LRSQ2. Note that the existence of a positive feedback effect from LRSQ to PIN still supports the positive PIN effect on firm-specific return variation, indicating that informed trade-return variation relation might partly be attributed to the feedback effect from LRSQ to PIN.

References

  • Akay O, Cyree K, Griffiths M, Winters D (2012) What does PIN identify? Evidence from the T-bill market. J Financ Mark 15:29–46

    Article  Google Scholar 

  • Amihud Y (2002) Illiquidity and stock returns: cross-section and time-series effects. J Financ Mark 5:31–56

    Article  Google Scholar 

  • Anandarajan A, Francis B, Hasan I, John K (2011) Value relevance of banks: global evidence. Rev Quant Financ Acc 36:33–55

    Article  Google Scholar 

  • Andersen T (1996) Return volatility and trading volume: an information flow interpretation of stochastic volatility. J Financ 51:169–204

    Article  Google Scholar 

  • Ascioglu A, Hegde S, Krishnan G, McDermot J (2012) Earnings management and market liquidity. Rev Quant Financ Acc 38:257–274

    Article  Google Scholar 

  • Avramov D, Chordia T, Goyal A (2006) The impact of trades on daily volatility. Rev Financ Stud 19:1241–1277

    Article  Google Scholar 

  • Barber B, Odean T (2008) All that glitters: the effect of attention and news on the buying behavior of individual and institutional investors. Rev Financ Stud 21:785–818

    Article  Google Scholar 

  • Barberis N, Shleifer A, Wurgler J (2005) Comovement. J Financ Econ 75:283–317

    Article  Google Scholar 

  • Bennett J, Sias R, Starks L (2003) Greener Pastures and the impact of dynamic institutional preferences. Rev Financ Stud 16:1203–1238

    Article  Google Scholar 

  • Bharath S, Pasquariello P, Wu G (2009) Does asymmetric information drive capital structure decisions? Rev Financ Stud 22:3211–3243

    Article  Google Scholar 

  • Brandt M, Brav A, Graham J, Kumar A (2010) The idiosyncratic volatility puzzle: time trend or speculative episodes? Rev Financ Stud 23:863–899

    Article  Google Scholar 

  • Brockman P, Chung D (2008) Investor protection, adverse selection, and the probability of informed trading. Rev Quant Financ Acc 30:111–131

    Article  Google Scholar 

  • Brockman P, Yan X (2009) Block ownership and firm-specific information. J Bank Financ 33:308–316

    Article  Google Scholar 

  • Cahan S, Emanuel D, Sun J (2009) The effect of earnings quality and country-level institutions on the value relevance of earnings. Rev Quant Financ Acc 33:371–391

    Article  Google Scholar 

  • Campbell J, Lettau M, Malkiel B, Xu Y (2001) Have individual stocks become more volatile? An empirical exploration of idiosyncratic risk. J Financ 56:1–43

    Article  Google Scholar 

  • Chan K, Hameed A (2006) Stock price synchronicity and analyst coverage in emerging markets. J Financ Econ 80:115–147

    Article  Google Scholar 

  • Chen Q, Goldstein I, Jiang W (2007) Price informativeness and investment sensitivity to stock price. Rev Financ Stud 20:619–650

    Article  Google Scholar 

  • Chorida T, Swaminathan B (2000) Trading volume and cross-autocorrelations in stock returns. J Finance 55:913–935

    Article  Google Scholar 

  • Chung K, Chuwonganant C, McCormick D (2006) Order preferencing, adverse-selection costs, and the probability of information-based trading. Rev Quant Financ Acc 27:343–364

    Article  Google Scholar 

  • Dasgupta S, Gan J, Gao N (2010) Transparency, price informativeness, stock return synchronicity: theory and evidence. J Financ Quant Anal 45:1189–1220

    Article  Google Scholar 

  • Drew M, Marsden A, Veeraraghavan M (2007) Does idiosyncratic volatility matter? New Zealand evidence. Rev Pac Basin Financ Markets Pol 10:289–308

    Article  Google Scholar 

  • Duarte J, Young L (2009) Why is PIN priced? J Financ Econ 91:119–138

    Google Scholar 

  • Durnev A, Morck R, Yeung B, Zarwin P (2003) Does greater firm-specific return variation mean more or less informed stock pricing? J Account Res 41:797–836

    Article  Google Scholar 

  • Durnev A, Morck R, Yeung B (2004) Value-enhancing capital budgeting and firm-specific stock return variation. J Financ 59:65–105

    Article  Google Scholar 

  • Easley D, O’Hara M (2003) Microstructure and asset pricing, In: Constantinides G, Harris M, Stulz R (eds) Handbook of the econ of finance, vol 1. Elsevier, Amsterdam, pp 1021–1051

  • Easley D, Keifer N, O’Hara M (1997) One day in the life of a very common stock. Rev Financ Stud 10:805–835

    Article  Google Scholar 

  • Easley D, Hvidkjaer S, O’Hara M (2002) Is information risk a determinant of asset returns? J Financ 57:2185–2221

    Article  Google Scholar 

  • Easley D, Engle R, O’Hara M, Wu L (2008) Time-varying arrival rates of informed and uninformed traders. J Financ Econom 6:171–207

    Article  Google Scholar 

  • Fama E, Macbeth J (1973) Risk, return, and equilibrium-empirical tests. J Polit Econ 83:607–636

    Article  Google Scholar 

  • Foster F, Viswanathan S (1995) Can speculative trading explain the volume–volatility relation? J Bus Econ Stat 13:379–396

    Google Scholar 

  • Foucault T, Sraer D, Thesmar D (2011) Individual investors and volatility. J Financ 66:1369–1406

    Article  Google Scholar 

  • French K, Roll R (1986) Stock return variances: the arrival of information and the reaction of traders. J Financ Econ 17:5–26

    Article  Google Scholar 

  • Gallant A, Rossi P, Tauchen G (1992) Stock prices and volume. Rev Financ Stud 5:199–242

    Article  Google Scholar 

  • Gervais S, Ron K, Mingelgrin D (2001) The high volume return premium. J Financ 56:877–919

    Article  Google Scholar 

  • Glosten L, Milgrom P (1985) Bid, ask, and transaction prices in a specialist market with heterogeneously informed traders. J Financ Econ 14:71–100

    Article  Google Scholar 

  • Hasbrouck J (2009) Trading costs and returns for US equities: estimating effective costs from daily data. J Financ 64:1445–1477

    Article  Google Scholar 

  • Hu C, Liu S (2013) The implications of low R2: evidence from China. Emerg Markets Financ Trade 49:17–32

    Article  Google Scholar 

  • Hutton A, Marcus A, Tehranian H (2009) Opaque Financial reports, R2, and crash risk. J Financ Econ 94:67–86

    Article  Google Scholar 

  • Hwang L, Lee W, Lim S, Park K (2013) Does information risk affect the implied cost of equity capital? An analysis of PIN and adjusted PIN. J Account Econ 55:148–167

    Article  Google Scholar 

  • Jin L, Myers S (2006) R2 around the world: new theory and new tests. J Financ Econ 79:257–292

    Article  Google Scholar 

  • Karpoff J (1987) The relation between price changes and trading volume: a survey. J Financ Quant Anal 22:109–126

    Article  Google Scholar 

  • Kelly P (2005) Information efficiency and firm-specific return variation. Arizona State University, Working paper

    Book  Google Scholar 

  • Krishnaswami S, Subramaniam V (1999) Information asymmetry, valuation, and the corporate spin-off decision. J Financ Econ 53:73–112

    Article  Google Scholar 

  • Kryzanowski L, Lazrak S (2011) Informed traders of cross-listed shares trade more in the domestic market around earnings releases. Rev Quant Financ Acc 36:1–31

    Article  Google Scholar 

  • Kumar R, Popescu M (2013) The implied intra-day probability of informed trading. Rev Quant Financ Acc. doi:10.1007/s11156-013-0345-0

    Google Scholar 

  • Kyle A (1985) Continuous auctions and insider trading. Econometrica 53:1315–1336

    Article  Google Scholar 

  • Lee D, Liu M (2011) Does more information in stock price lead to greater or smaller idiosyncratic return volatility? J Bank Finance 35:1563–1580

    Article  Google Scholar 

  • Lee C, Ready M (1991) Inferring trade direction from intraday data. J Financ 46:733–746

    Article  Google Scholar 

  • Lei Q, Wu G (2005) Time-varying informed and uninformed trading activities. J Financ Markets 8:153–181

    Article  Google Scholar 

  • Li B, Rajgopal S, Venkatachalam M (2012) R2 and idiosyncratic risk are not inter-changeable, Working paper, Duke University

  • Lin H, Ke W (2011) A computing bias in estimating the probability of informed trading. J Financ Markets 14:625–640

    Article  Google Scholar 

  • Luo M, Chen T, Yan I (2013) Price informativeness and institutional ownership: evidence from Japan. Rev Quant Financ Acc. doi:10.1007/s11156-013-0355-y

    Google Scholar 

  • Morck R, Yeung B, Yu W (2000) The information content of stock markets: why do emerging markets have synchronous stock price movements? J Financ Econ 59:215–260

    Article  Google Scholar 

  • O’Hara M (1995) Market Microstructure theory. Blackwell, Basil

    Google Scholar 

  • Piotroski D, Roulstone D (2004) The influence of analysts, institutional investors, and insiders on the incorporation of market, industry, and firm-specific information into stock prices. Account Rev 79:1119–1151

    Article  Google Scholar 

  • Roll R (1988) R2. J Finance 43:541–566

  • Schwert W (1990) Stock volatility and the crash of ’87. Rev Financ Stud 3:77–102

    Article  Google Scholar 

  • Suominen M (2001) Trading volume and information revelation in stock markets. J Financ Quant Anal 36:545–566

    Article  Google Scholar 

  • Tay A, Ting C, Tse Y, Warachka M (2009) Using high-frequency transaction data to estimate the probability of informed trading. J Financ Econom 7:288–311

    Article  Google Scholar 

  • Wang J, Wu C, Yu E (2012) Order Imbalance, Liquidity, and Returns of the U.S. Treasury Market. Rev Pac Basin Financ Markets Pol 15:1250010

    Google Scholar 

  • West K (1988) Dividend innovations and stock price volatility. Econometrica 56:37–61

    Article  Google Scholar 

  • Xu Y, Malkiel B (2003) Investigating the behavior of idiosyncratic volatility. J Bus 76:613–644

    Article  Google Scholar 

  • Yan Y, Zhang S (2012) An improved estimation method and empirical properties of the probability of informed trading. J Bank Financ 36:454–467

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Hagan School of Business, Iona College, New Rochelle, NY, 10801, USA

    Moonsoo Kang

  2. Sy Syms School of Business, Yeshiva University, 500 W. 185th Street, New York, NY, 10033, USA

    Kiseok Nam

Authors
  1. Moonsoo Kang
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Kiseok Nam
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Kiseok Nam.

Rights and permissions

Reprints and permissions

About this article

Cite this article

Kang, M., Nam, K. Informed trade and idiosyncratic return variation. Rev Quant Finan Acc 44, 551–572 (2015). https://doi.org/10.1007/s11156-013-0417-1

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11156-013-0417-1

Keywords

JEL Classification

Search

Navigation