Investor Uncertainty and Order Flow Information

This paper proposes an alternative explanation for the price impact of trades created by information that is carried in the order ßow. Unlike models that consider information asymmetry about the future cash ßows (or liquidation value) of the asset, the approach here postulates uncertainty about the distribution of preferences and endowments of investors. This “investor uncertainty” results in prices moving on trades and therefore creates a spread between the bid and the ask. Greater investor uncertainty increases the spread, decreases expected trading volume, and lowers the welfare of all investors in the market. Hence, all investors are better off if market makers are expert in assessing the distribution of preferences and endowments of the investor population. The information content of the order ßow is further investigated by applying an econometric spread decomposition procedure to data generated by simulating the model. The results indicate that a signiÞcant adverse selection component of the spread can arise solely due to the informational effects of investor uncertainty. Investor Uncertainty and Order Flow Information Why do trades move prices? A leading explanation in the market microstructure literature involves information asymmetry among investors about the future cash ßows of assets. When some investors have private information about an asset and can potentially trade on it to make a proÞt, others attempt to infer the private information from the order ßow and prices adjust to reßect the information. This inference problem has been analyzed in numerous papers, mostly following general modeling frameworks developed by Glosten and Milgrom (1985) and Kyle (1985). In these models, risk neutral and competitive market makers receive orders from informed investors (who are endowed with information about the liquidation payoffs of an asset) and uninformed investors. These models characterize the manner in which information about future cash ßows is incorporated into prices, and in particular establish information asymmetry as a cause for the price impact of trades that creates the spread between the bid and ask prices. This paper advances an alternative explanation for the price impact of trades: uncertainty about the preferences and endowments of investors in the market (henceforth “investor uncertainty”). Conceptually, an asset’s price is determined jointly by the future cash ßows associated with the asset and the preferences and endowments of the investors who demand the asset. Differential information about either future cash ßows or the preferences and endowments of the investors can and should affect that price. The assumption of uncertainty in the market about the distribution of investors’ preferences and endowments seems rather intuitive since these attributes of investors are inherently unobservable. In addition, different investors arrive to Þnancial markets at different time, further complicating the task of learning about the overall distribution of preferences and endowments of the investor population. This uncertainty about the investor population creates a problem with respect to pricing the asset. Order ßow communicates the trading desires of investors and can be used to extract information about the preferences and endowments of investors and hence about the value of the asset.