Sanders S. Chang

Information Asymmetry, Liquidity, and Stock Returns

We develop a new measure for the probability of informed trading, called PCP. Using double-sorted portfolios, we find that excess returns increase from low to high PCP portfolios. In regression analysis, the effect of PCP on returns is significantly positive after controlling for illiquidity effect. The point estimate of the coefficient on one PCP is 3.788, suggesting that a difference of 10 percentage points in the PCP between two stocks leads to a difference in expected returns of 4.5 percent annually. Thus, the effect is also economically significant. Our results support the information asymmetry hypothesis that information risk is priced.