ssrn - Order flow and prices Ekkehart Boehmer and Julie Wu*...

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Order flow and prices Ekkehart Boehmer and Julie Wu * Mays Business School Texas A&M University College Station, TX 77845-4218 March 14, 2006 Abstract We provide new evidence on a central prediction of microstructure theory, that order flow is related to prices. We examine proprietary data on a broad panel of NYSE-listed stocks that reveal daily order imbalances by institutions, individuals, and market makers. We can further differentiate regular institutional trades from institutional program trades. Our results indicate that order imbalances from different trader types play distinctly different roles in price formation. Institutions and individuals are contrarians with respect to previous-day returns, but differ in the effect their order imbalances have on contemporaneous returns. Institutional imbalances are positively related to contemporaneous returns, and we provide cross-sectional evidence that this relationship is likely to be the result of firm-specific information institutions have. Individuals, specialists, and other traders provide liquidity to these actively trading institutions. Our results also suggest a special role for institutional program trades. Institutions choose program trades when they have no firm-specific information and can afford to trade passively. As a result, program trades provide liquidity to the market. Finally, both institutional non- program and individual imbalances (information which is not available to market participants) have predictive power for next-day returns. * Email addresses: [email protected] , [email protected] . We thank Kerry Back for his comments.
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2 Order flow and prices A central prediction of market microstructure theory is that order flow affects prices. This follows from inventory models, where market makers temporarily adjust prices in response to incoming orders (Garman, 1976; Amihud and Mendelson, 1980; Stoll, 1978; Ho and Stoll, 1981). It also follows from information-based models where some traders have information about future asset value, so their trades lead to permanent price adjustments (Glosten and Milgrom, 1985; Kyle, 1985; Easley and O’Hara, 1987). The prediction that order flow affects prices is robust to competition among informed traders (Holden and Subrahmanyam, 1992), endogenous order sizes (Back and Baruch, 2005), and the consideration of strategic uninformed traders (Admati and Pfleiderer, 1988; Spiegel and Subrahmanyam, 1992). Empirical research is almost uniformly consistent with this basic prediction and generally supports both inventory and information effects. Ho and Macris (1984) document that an options specialist adjusts prices in a way that is consistent with inventory models. Other early studies compare stock return variance during the trading day with overnight variance. French and Roll (1986) find much higher variance while markets are open and attribute this finding to the activities of informed traders whose information is impounded into prices. Hasbrouck
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This note was uploaded on 12/08/2011 for the course CIS 625 taught by Professor Michaelkearns during the Spring '12 term at Pennsylvania State University, University Park.

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ssrn - Order flow and prices Ekkehart Boehmer and Julie Wu*...

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