The impact of information on security prices is a fundamental building block for the modern finance theory. Literature has well established that public information arrivals may cause volatility of stock prices, and that private information about asset values may be conveyed by signed trading volume or net order flows. However, how public and private information are eventually impounded into stock prices remains a subject of considerable debate in any types of financial markets.
The focus of this study is on how public and private information are incorporated in stock prices via order submissions and executions in a pure order-driven market. Specifically, we address three research questions: Firstly, are order flows informative on stock returns? Secondly, do public information arrivals increase or decrease the informativeness of order flows on stock returns? Thirdly, how does the intensity of public information arrivals affect the relation between price volatility, trading volume and the shape of the order book?
The Australian Securities Exchanges (ASX) provides us a unique proxy for public information arrivals in our analysis. Previous studies often use news headlines from commercial news outlets as a proxy for public information, and thus may suffer from three constraints: the first is that the information is not centrally released, so prior trading on the information might exist; the second is that the information does not have a time-stamped feature for intraday analysis; and the third one is that the information may not originate from the company. The ASX, with the continuous disclosure regime that releases centrally time-stamped announcements related to specific companies, enable us to overcome these limitations by providing a more timely and accurate measure of public information arrivals.
The process of incorporating public and private information in stock prices via order submission and execution can be studied in two settings. The first one examines the direction of stock price changes (the mean effect), and its relation to order flows, where both are signed variables. If informed traders use both market orders and limit orders to exploit their private information about asset values, we should expect order flows, which are measured by trade imbalance and order book imbalance, are informative on stock returns. This analysis provides insight into the debate over which orders (market orders or limit orders) are used by informed traders to exploit their information advantages. If informed traders are more likely to use market orders as proposed in Glosten (1994) and Seppi (1997), we should find that trade imbalance is more informative on price changes than order book imbalance. On the other hand, if informed traders are more likely to use limit orders as proposed in Chakravarty and Holden (1995), Bloomfield et al. (2005), Anand et al. (2005), Wald and Horrigan (2005), and Kaniel and Liu (2006), we should find that order book imbalance is more informative on stock price changes than trade imbalance.
In our study, trade imbalance is measured basing on the difference between buyer initiated trades and seller-initiated trades . The order book imbalance is measured basing on information from the slope of the order book at a given interval. In a related study, Cao et al. (2009) provide evidence that imbalances in order quantities and order prices are significantly related to short-term returns in the ASX. We differ from Cao et al. (2009) by arguing that traders take into account the dynamic interaction between quantities and prices when submitting their orders. We thus rely on order-book slopes, which combine both order quantities and order prices. The order book slope is presumably better to convey information about the state of the order book because the submitted order quantities are mutually contingent or dependent on the submitted order prices. We then use the relative or absolute differences between the slope of the demand curve and that of the supply curve of the order book as a proxy for the order book imbalance.
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