Investor Uncertainty and Order Flow Information

Abstract

This paper proposes an alternative explanation for the price impact of trades created by information that is carried in the order flow. Unlike models that consider information asymmetry about the future cash flows (or liquidation value) of the asset, the approach here postulates uncertainty about the distribution of preferences and endowments of investors. This investor uncertainty results in prices moving on trades and therefore creates a spread between the bid and the ask. Greater investor uncertainty increases the spread, decreases expected trading volume, and lowers the welfare of all investors in the market. Hence, all investors are better off if market makers are expert in assessing the distribution of preferences and endowments of the investor population. The information content of the order flow is further investigated by applying an econometric spread decomposition procedure to data generated by simulating the model. The results indicate that a significant adverse selection component of the spread can arise solely due to the informational effects of investor uncertainty.