The Excess Returns Puzzle: Interactions with Information Asymmetry Variables

Abstract

This paper examines the impact of volatility on information asymmetry in explaining excess returns. We find that illiquidity is significant at different levels of volatility but that adverse selection costs are not significant during periods of extreme volatilities, i.e., very high and very low volatilities. The insignificant adverse selection costs during extreme volatility periods can be attributed to irrational behavior and the biases of liquidity traders. These traders are overconfident during low volatility periods and ignore information asymmetry, thereby rendering adverse selection costs insignificant. They are too pessimistic during high volatility periods and ignore their inferior informational situation.

Keywords: Volatility, information asymmetry, liquidity

JEL Classification: G10