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Is Information Risk Priced?
Evidence from the Price Discovery of Large Trades
Chuan Yang Hwang
Nanyang Technological University
and
Xiaolin Qian
Nanyang Technological University
Literature

Theoretical

Easley and O'Hara (2004)



Hughes, Liu, and Liu (2007)


Asset demand are affected by information asymmetry: Informed investors hold
more (less) of the assets with good (bad) information. The opposite is true for
uninformed investors.
Uninformed investors cannot diversified the risk of information asymmetry; they
demand higher return to compensate for the risk.
The risk of information asymmetry can be diversified in large economy;
information risk should not be priced.
Empirical
 Easley, Hvidkjaer, and O'Hara (2002)


Duarte and Young (2007)


Probability of information-based trading (PIN) is priced
PIN is priced because it captures the illiquidity
Aktas, de Bodt, Declerck, and Van Oppens (2007) Aslan, Easley,
Hvidkjaer, and O'Hara (2007) Easley, Hvidkjaer, and O'Hara (2005)


Convergence problem of PIN, the MLE cannot be estimated for stocks with very
large numbers of trades
3.6% in the 2001 sample do not obtain PIN estimates; these stocks account for
23.7% of total market capitalization.
Main Results





We use the price discovery of large trade, denoted as ECIN, to
measure information risk.
Information risk is priced; ECIN is positively related with stock
return, controlling for beta, size, b/m, illiquidity and momentum
Portfolio, long in high ECIN and short in low ECIN, has a FF four
factor risk-adjusted return of 0.43% per month
ECIN dominated PIN in the asset pricing test, with or w/o
controlling for illiquidity.
ECIN subsumes Amihuid ILLIQ in the asset pricing test


suggesting the information risk matters beyond the illiquidity
pricing impact effect of ILLIQ has its origin in information risk.
Motivating ECIN

Private information is revealed in the sequence of
trade prices.




Glosten and Milgrom (1985) and Kyle (1985)
Price discovery: incorporation of new information into
stock price(O’Hara,2003)
Llorente et al. (2002), trade price is likely to continue if
the trade is driven by information; particular true for
trade of large volume
Informed traders prefer large trade

Easley and O'Hara (1987)



Uninformed trade in both large and small size
Informed trade only in large size
Barclay and Warner (1993)

Informed trades concentrate in the trades of 1000 to 9900
shares
Motivating ECIN

Large trade price and small trade prices are cointegrated


The price impact of the large trade can be estimated via VECM.
Harris et al. (1995) , Hasbrouck (1995) , Eun and Sabherwal
(2003) , Werner and Kleidon (1996) have used the same
concept (co-integration and VECM) to study the price discovery
function of different markets when the same securities are traded
in these markets simultaneously. .
Large Trade and Small Trade Classification

Lee (1992), Lee and Radhakrishna (2000) and Hvidkyaer
(2006)



Large and small trades are defined based on investment value
Avoid the sensitivity to small stock price change
 $20, $10,000, 100-500 shares
 $20⅛, $10,000, 100-400 shares
Conditional on firm size
VECM
g
g
Pt  c   ( P  P )   i Pt i    i Pt i  
L
L
0
L
L
t 1
S
t 1
L
i 1
S
i 1
g
L
t
g
Pt  c   ( P  P )    j Pt  j    j Pt  j  
S
S
0
S
L
t 1
S
t 1
L
S
j 1
j 1
• P  P , the deviation from the equilibrium, is a stationary process
with mean zero.
L
t 1
S
t 1
• αL <0; αS >0;
• If αL closer to zero, PL reflects more (private) information.
αL is the asymmetric information risk measure (ECIN)
S
t
Hypotheses
1) There is more informed trading and price
discovery in large trades than in small trades,
so |αL|< αS
2) αL is positively related to the degree of
information asymmetry.
3) If the asymmetric information risk is a priced
risk, αL will be positively related to the future
stock returns.
Data Samples


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
NYSE and AMEX
January 1983-December 2005 for ECIN estimation
January 1984-December 2006 for asset pricing test
VECM is estimated for each firm each calendar year

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
augmented Dickey-Fuller unit-root test
Johansen cointegration test
32,706 firm-years
Table 3 VECM Parameters
 In total, we have 61.53% firm-years with |αL|< αS
The Correlation of ECIN with Other Information
Asymmetry Measures

Probability of Information-Based Trading (PIN)



Easley, Kiefer, O'Hara, and Paperman (1996), Easley, Hvidkjaer and
O’Hara(2002)
Bid-ask Spread
Firm Size
Table 5 Asset Pricing Tests
Table 7 Compare ECIN with PIN
Table 8 Economic Significance of ECIN
Rit  g0t  g1t HECIN it 1  g2t LECIN it 1  g3t (  it 1 - AVG t 1 )  g4t ( SIZE it 1 - AVGSIZE t 1 )
 g5t ( BM it 1 - AVGBM t 1 )  g6t ( MOM it 1 - AVGMOM t 1 )
Table 8 Economic Significance of ECIN
Conclusion



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Information risk is priced.
Information risk matters in the stock return
beyond the illiquidity.
ECIN subsumes PIN and ILLIQ in the asset
pricing test.
ECIN is a more precise information risk
measure that can find a great many
applications in corporate finance and
accounting literature.
Thanks!