Is Information Risk Priced? Evidence from the Price Discovery of Large Trades Chuan Yang Hwang Nanyang Technological University and Xiaolin Qian Nanyang Technological University

Literature Theoretical Easley and O'Hara (2004) Asset demand are affected by information asymmetry: Informed investors hold more (less) of the assets with good (bad) information. The opposite is true for uninformed investors. Uninformed investors cannot diversified the risk of information asymmetry; they demand higher return to compensate for the risk. Hughes, Liu, and Liu (2007) The risk of information asymmetry can be diversified in large economy; information risk should not be priced. Empirical Easley, Hvidkjaer, and O'Hara (2002) Probability of information-based trading (PIN) is priced Duarte and Young (2007) PIN is priced because it captures the illiquidity Aktas, de Bodt, Declerck, and Van Oppens (2007) Aslan, Easley, Hvidkjaer, and O'Hara (2007) Easley, Hvidkjaer, and O'Hara (2005) Convergence problem of PIN, the MLE cannot be estimated for stocks with very large numbers of trades 3.6% in the 2001 sample do not obtain PIN estimates; these stocks account for 23.7% of total market capitalization.

Main Results We use the price discovery of large trade, denoted as ECIN, to measure information risk. Information risk is priced; ECIN is positively related with stock return, controlling for beta, size, b/m, illiquidity and momentum Portfolio, long in high ECIN and short in low ECIN, has a FF four factor risk-adjusted return of 0.43% per month ECIN dominated PIN in the asset pricing test, with or w/o controlling for illiquidity. ECIN subsumes Amihuid ILLIQ in the asset pricing test suggesting the information risk matters beyond the illiquidity pricing impact effect of ILLIQ has its origin in information risk.

Motivating ECIN Private information is revealed in the sequence of trade prices. Glosten and Milgrom (1985) and Kyle (1985) Price discovery: incorporation of new information into stock price(O’Hara,2003) Llorente et al. (2002), trade price is likely to continue if the trade is driven by information; particular true for trade of large volume Informed traders prefer large trade Easley and O'Hara (1987) Uninformed trade in both large and small size Informed trade only in large size Barclay and Warner (1993) Informed trades concentrate in the trades of 1000 to 9900 shares

Motivating ECIN Large trade price and small trade prices are co- integrated The price impact of the large trade can be estimated via VECM. Harris et al. (1995), Hasbrouck (1995), Eun and Sabherwal (2003), Werner and Kleidon (1996) have used the same concept (co-integration and VECM) to study the price discovery function of different markets when the same securities are traded in these markets simultaneously..

Large Trade and Small Trade Classification Lee (1992), Lee and Radhakrishna (2000) and Hvidkyaer (2006) Large and small trades are defined based on investment value Avoid the sensitivity to small stock price change $20, $10,000, shares $20⅛, $10,000, shares Conditional on firm size

VECM, the deviation from the equilibrium, is a stationary process with mean zero. α L 0; If α L closer to zero, P L reflects more (private) information. α L is the asymmetric information risk measure (ECIN)

Hypotheses 1) There is more informed trading and price discovery in large trades than in small trades, so |α L |< α S 2) α L is positively related to the degree of information asymmetry. 3) If the asymmetric information risk is a priced risk, α L will be positively related to the future stock returns.

Data Samples NYSE and AMEX January 1983-December 2005 for ECIN estimation January 1984-December 2006 for asset pricing test VECM is estimated for each firm each calendar year augmented Dickey-Fuller unit-root test Johansen cointegration test 32,706 firm-years

Table 3 VECM Parameters  In total, we have 61.53% firm-years with |α L |< α S

The Correlation of ECIN with Other Information Asymmetry Measures Probability of Information-Based Trading (PIN) Easley, Kiefer, O'Hara, and Paperman (1996), Easley, Hvidkjaer and O’Hara(2002) Bid-ask Spread Firm Size

Table 5 Asset Pricing Tests

Table 7 Compare ECIN with PIN

Table 8 Economic Significance of ECIN

Conclusion Information risk is priced. Information risk matters in the stock return beyond the illiquidity. ECIN subsumes PIN and ILLIQ in the asset pricing test. ECIN is a more precise information risk measure that can find a great many applications in corporate finance and accounting literature.

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