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A Simple Multimarket Measure of Information Asymmetry MANAGEMENT SCIENCE Articles in Advance, pp. 1–26 http://pubsonline.informs.org/journal/mnsc/ ISSN 0025-1909 (print), ISSN 1526-5501 (online) A Simple Multimarket Measure of Information Asymmetry Travis L. Johnson,a Eric C. Sob a McCombs School of Business, The University of Texas at Austin, Austin, Texas 78712; b Sloan School of Management, Massachusetts Institute of Technology, Cambridge, Massachusetts 02142 Contact: [email protected] (TLJ); [email protected] (ECS) Received: November 22, 2015 Abstract. We develop and implement a new measure of information asymmetry among Accepted: July 1, 2016 traders. Our measure is based on the intuition that informed traders are more likely Published Online in Articles in Advance: than uninformed traders to generate abnormal volume in options or stock markets. We January 18, 2017 formalize this intuition theoretically and compute the resulting multimarket information https://doi.org/10.1287/mnsc.2016.2608 asymmetry measure (MIA) for firm-days as a function of unsigned volume totals and without estimating a structural model. Empirically, MIA has many desirable properties: it Copyright: © 2017 INFORMS is positively correlated with spreads, price impact, and absolute order imbalances; predicts future volatility; is an effective conditioning variable for trading strategies stemming from price pressure; and detects exogenous shocks to information asymmetry. History: Accepted by Lauren Cohen, finance. Keywords: information asymmetry • market microstructure • options • liquidity 1. Introduction informed trade. In this paper, we address this measure- Asymmetric information plays a critical role in ment problem by developing a new proxy for infor- reconciling classical economic theory with observed mation asymmetry among traders that leverages how economic behavior. The severity and content of trades are dispersed across option and stock markets. asymmetric information influences most interactions We empirically implement our measure and run a bat- between economic agents, particularly in cases of tery of tests that yield support for its use as a proxy for adverse selection or moral hazard. As a result, asym- information asymmetry among traders. metric information is one of the most fundamentally Our multimarket information asymmetry measure, important concepts studied by modern economists. It MIA, is a simple function of unsigned volume totals is of particular interest to financial economists because based on the idea that informed traders face a leverage one of the primary social benefits of an active securities market is that it aggregates disparate information into constraint that generates a trade-off between smaller market prices. Therefore, understanding the influence price impact in equity markets and additional leverage of information asymmetry on the interaction between in options markets. Because informed traders receive agents is essential for understanding the outcomes and correlated signals, this trade-off causes the fraction of operation of financial markets. informed trade occurring in options versus equity mar- Most models of trading in financial markets involve kets to fluctuate over time depending on the nature two types of agents: those who trade because they of the signals informed traders receive. In contrast, have an information advantage and those who trade uninformed traders’ choice of trading venues is rel- without an information advantage for reasons such as atively uncorrelated, and thus the fraction of unin- a desire for liquidity or hedging. The prevalence of formed trade in each market is relatively stable over informed trade affects liquidity, transaction costs, and time. As a result, periods of heightened information trading volumes, and it can also help to explain mar- asymmetry manifest in abnormally high or low option- ket failures. For this reason, an important variable in to-stock volume ratios (O/S, a measure first studied in most theoretical and empirical work on information Roll et al. 2010), relative to the level of O/S that occurs economics in financial markets is the fraction of vol- Downloaded from informs.org by [18.111.10.101] on 02 February 2017, at 06:04 . For personal use only, all rights reserved. in the absence of private information. In Section 3,we ume originating from informed traders. formalize this intuition and derive MIA for firm j on Measuring the fraction of volume that is informed day t as presents a significant challenge because it is inherently O S M unobservable and time-varying. Thus, a central goal ⇤ | j, t / j, t − j, t | MIAj, t + , (1) in studying information asymmetry in financial mar- Oj, t Sj, t Mj, t kets is to develop proxies that can be expressed as / a function of observable inputs and whose varia- where Mj, t is an estimate of average O/S in the absence tion captures empirically measurable repercussions of of informed trade. 1 Johnson and So: A Simple Multimarket Measure of Information Asymmetry 2 Management Science, Articles in Advance, pp. 1–26, © 2017 INFORMS Compared to alternative proxies for information in options markets, reflecting the possibility that unin- asymmetry among traders, MIA has significant advan- formed trades, such as those emanating from mutual tages in terms of its ease of implementation, clarity fund flows or index rebalancing, also generate varia- of interpretation, and empirical effectiveness. Alterna- tion in O/S. tive proxies generally fall within two broad categories: In our extended model’s equilibrium, although simple characteristics of the stock, and structural esti- informed traders trade stocks and options simultane- mates of model parameters. Proxies based on simple ously to mitigate price impact, they weigh the addi- characteristics like firm size and analyst coverage have tional leverage and nonlinearity offered by options the advantage of being easy to calculate and intuitively markets against the larger price impact, leading to correlated with information asymmetry, but carry the substantial variations in the fraction of their volume disadvantages of being noisy and difficult to interpret they concentrate in options markets. As a result, we because they are also correlated with several confound- show deviations in O/S from its typical value indi- ing factors such as liquidity and expected cash flows cate informed trade, and MIA is an effective proxy (e.g., in Lee and So 2017). Recognition of these disad- for information asymmetry, as long as the volatility of vantages gave rise to structural estimates of informa- O/S driven by the random fluctuation of uninformed tion asymmetry among traders, including the “PIN” trader demands does not exceed the volatility of O/S 1 measure in Easley et al. (1996). driven by the informed trader’s equilibrium strategy. Structural estimates such as PIN have the advan- In Section 2, we discuss empirical evidence from prior tage of a theoretical connection to information asym- research suggesting this condition is met in practice. metry not confounded by liquidity or cash flows, but Because our model shows MIA’s effectiveness also carry the disadvantage of being computationally depends on the relative likelihood informed and unin- intensive because they require signing the direction formed traders generate abnormal O/S, we explore of trades (i.e., buys versus sells), which has become MIA’s validity empirically. Specifically, we compute increasingly problematic due to the accelerated fre- MIA for a panel of firm-days and subject it to a series of quency of trades in modern financial markets (Easley empirical tests. We divide our main empirical tests into et al. 2012). Furthermore, Duarte et al. (2015) show three categories we refer to as (i) associations, (ii) pre- that measures based on estimates of order imbalances dictions, and (iii) conditioning. alone, including PIN, are ineffective and note that “a In our associations tests, we show MIA is posi- different approach involving variables other than order tively associated with three repercussions of informa- flow is necessary to generate useful inferences about tion asymmetry: bid-ask spreads, price impact, and the arrival of informed trade” (p. 1).2 absolute order imbalances. These results provide sup- Our approach responds to this call by leveraging port for MIA and are consistent with the predictions the dispersion of trades across options and stock mar- kets. The addition of a second market allows us to of standard microstructure models (e.g., Glosten and identify the fraction of traders with an information Milgrom 1985, Kyle 1985) that illiquidity increases advantage using abnormal volume imbalances across with the degree of information asymmetry among the two markets, as opposed to requiring estimates traders. In our prediction tests, we show that MIA pos- of imbalances in buyer- versus seller-initiated trades. itively predicts future volatility incremental to contem- Additionally, MIA can be estimated at the daily level, poraneous volumes and volatilities. This corroborates which allows researchers to study changes in informa- the predictions of microstucture models with time- tion asymmetry in short windows surrounding infor- varying information arrival (e.g., Easley and O’Hara mation events. 1987, Easley et al. 1998) that informed trade increases We formalize the intuition behind MIA in a theoreti- before the arrival of news. To mitigate concerns that cal setting. As a baseline case, we first show that when a MIA simply reflects expectations of volatility derived constant fraction of uninformed trade occurs in options
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