Is Information Risk Priced?: Evidence from the Price Discovery of Large Trades

Abstract

We develop an information risk measure (ECIN) based on the price discovery of large trades. As the price series of large trades and small trades are cointegrated, the price discovery of trades can be easily estimated via the vector error-correction model (VECM). Intuitively, we use the VECM to study how a temporary gap between the large trade price and the small trade price for the same stock is closed. If most of the gap is closed through adjustment in the small trade price with little movement in the large trade price, this indicates large trade price has been closer to the long-run equilibrium price and hence that the large trade price has a greater price discovery function for the stock in question. Since informed traders prefer to trade in large size, firms whose large trades have a larger price discovery are deemed to have larger information risk. An important feature of ECIN that is inherent to its construction is that higher ECIN also means lower illiquidity. This feature helps to disentangle the pricing impact of information risk from that of illiquidity - a major advantage over other information risk measures in the asset pricing tests of information risk. We show that ECIN is priced and its predictive power of stock returns is far more significant than those of book-to-market and momentum.

Keywords: Information Risk, Price Discovery, Trade Size

JEL Classification: G12, G14