Academic journal article The International Journal of Business and Finance Research

Is There Asymmetric Information about Systematic Factors? Evidence from Commonality in Liquidity

Academic journal article The International Journal of Business and Finance Research

Is There Asymmetric Information about Systematic Factors? Evidence from Commonality in Liquidity

Article excerpt

ABSTRACT

This paper provides an empirical investigation of the hypothesis that there exists information asymmetry about systematic factors. Using a sample of 112 exchange traded funds (ETF) we provide evidence in support of this hypothesis. Furthermore, through the analysis of the the adverse selection component of the bid-ask spreads (lambdas) of these ETFs and all common stocks trading on the NYSE and the NASDAQ from January 1999 to December 2003, we provide strong evidence of commonality in the adverse selection component of liquidity. We use the estimated lambda of Standard and Poor's Depository Receipts (SPDRs) as a measure of information asymmetry about the U.S. equity market and find that these are (i) positively correlated with the lambdas of other exchange traded funds (ii) related to the lambdas on individual equity securities and (iii) they can be explained by measures of uncertainty about the aggregate market.

JEL: D82, G19

KEYWORDS: Liquidity, Information Asymmetry, Commonality

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

The market microstructure literature posits inventory risk and asymmetric information risk as the two drivers of liquidity. Chordia, Roll, and Subrahmanyam (2000) document commonality in liquidity. They use commonality to reveal the existence of asymmetric information effects on liquidity, but provide no evidence that asymmetric information has common components. We examine the liquidity of exchange traded funds (ETFs) and provide evidence that the asymmetric information portion of liquidity has common determinants. More specifically, we show that there is asymmetric information about systematic factors. Typically, the microstructure literature assumes that informed traders are privy to firm specific information such as a pending merger or product development. This idiosyncratic information would be diversified away in a large portfolio and knowledge about any one firm in the portfolio would not prove very useful in predicting the return on the portfolio (Hughes, Liu and Liu, 2007). Subrahmanyam (1991), Gorton and Pennacchi (1993) present models where the bundling of claims on individual assets into composite claims reduces informed traders' informational advantage.

As portfolios get large, the impact of asset specific information gets arbitrarily small and the adverse selection component of liquidity (lambda) will have to come through asymmetric information about common factors. Whether there is asymmetric information about systematic components of asset returns has not been determined. Subrahmanyam (1991) entertains the possibility and includes factor informed traders in his model. Aboody et al. (2005); Francis et. al. 2005; and Easley, Hvidkjaer, and O'Hara (2002) present models that allows for a common component in private information. Chordia, Roll, and Subrahmanyam (2002) consider asymmetric information for the aggregate market unlikely and adopt the inventory paradigm to explain the relation between order imbalances and market wide returns.

Knowing whether there is a common component to adverse selection is important for the following reasons. First, there is disagreement about its existence. Second, Gorton and Pennacchi (1993) show that the microstructure impact of idiosyncratic private information cannot be diversified away. Easley, Hvidkjaer, and O'Hara (2002), and Easley and O'Hara (2004) show that cumulative idiosyncratic information asymmetry affects asset returns. Asymmetric information about systematic factors is nondiversifiable and depending on its magnitude, also affects expected returns. Third, most textbooks on investing include sections on "Top Down" strategies and tactical asset allocation. Such approaches to investing rely on investors being able to avoid (select) asset categories or industries that will do relatively poorly (well). Absent information asymmetry about systematic factors, the value of these approaches is questionable. …

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