Understanding Order-Flow Volatility

Abstract

Given that order-flow is likely to be driven by differences in investors beliefs, a reasonable hypothesis is that order-flow volatility should be positively related to the level of investor heterogeneity. Motivated by this hypothesis, this study investigates the association between order-flow variability and various known proxies of divergence of opinions and informational differences. We find order-flow variability to be positively associated with trading volume, dispersion in analysts forecasts and the S&P 500 futures open interest (a proxy for market-wide divergence of opinions), and negatively associated with the adverse selection cost of trading. We also demonstrate a positive relation between order-flow variability and risk adjusted stock returns. In conclusion, we find evidence of co-movement in order-flow variability as well as in the adverse selection cost of trading and liquidity. Co-movement in order-flow variability appears to partially explain co-movement in liquidity.

Keywords: CAPM, Beta, Markowitz Mean-Variance Framework, Fama and French

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