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November 2, 2009
Liquidity Dynamics and Cross-Autocorrelations
Tarun Chordia,
Asani Sarkar,
and Avanidhar Subrahmanyam
Goizueta Business School, Emory University, 1300 Clifton Road, Atlanta, GA 30322,email: Tarun Chordia@bus.emory.edu, Phone: (404) 727-1620.
Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10038, email:Asani.Sarkar@ny.frb.org, Phone: (212) 720-8943.
Anderson Graduate School of Management, University of California at Los Angeles,110 Westwood Plaza, Los Angeles, CA 90095-1481, email: subra@anderson.ucla.edu,Phone: (310) 825-5355.We thank an anonymous referee, Hank Bessembinder (the editor), Je
Coles, ArturoEstrella, Michael Fleming, Akiko Fujimoto, Kenneth Garbade, Joel Hasbrouck, CharlesHimmelberg, Mark Huson, Aditya Kaul, Spencer Martin, Vikas Mehrotra, Albert Menkveld,Federico Nardari, Christine Parlour,
s astor, Sebastien Pouget, Joshua Rosenberg,Christoph Schenzler, Gordon Sick, Rob Stambaugh, Neal Stoughton, Marie Sushka, JiangWang, and seminar participants at Arizona State University, University of Alberta, Uni-versity of Calgary, the HEC (Montreal) Conference on New Financial Market Structures,and the Federal Reserve Bank of New York, for helpful comments. The views stated hereare those of the authors and do not necessarily re
ect the views of the Federal ReserveBank of New York, or the Federal Reserve System.
Liquidity Dynamics and Cross-Autocorrelations
This paper examines the relation between information transmission and cross-autocorrel-ations. We present a simple model where informed trading is transmitted from large tosmall stocks with a lag. In equilibrium, large stock illiquidity induced by informed tradingportends stronger cross-autocorrelations. Empirically, we
nd that the lead-lag relationincreases with lagged large stock illiquidity. Further, the lead from large stock order
ows to small stock returns is stronger when large stock spreads are higher. In addition,this lead-lag relation is stronger before macro announcements (when information-basedtrading is more likely) and weaker afterwards (when information asymmetries are lower).
I. Introduction
The manner in which information is impounded into prices has long been of primaryconcern in
nancial economics. While asset pricing theories in the presence of frictionlessmarkets allow for instantaneous di
usion of information, trading frictions impede thesmooth incorporation of information into prices. Understanding the impact of such fric-tions on price dynamics is of fundamental importance. Lo and MacKinlay (1990) (hence-forth LM) document an important pattern wherein the correlation between lagged large
rm returns and current small
rm returns is higher than the correlation between laggedsmall
rm returns and current large
rm returns. This points to some friction that pre-vents information from being incorporated into all stock prices simultaneously. Brennan,Jegadeesh, and Swaminathan (BJS) (1993) propose that the lead-lag patterns arise dueto di
erential speeds of adjustment of stocks to economy-wide shocks.
Thus, systematicdemand shocks should
rst be incorporated into the prices of the more actively-tradedlarger stocks resulting in the observed cross-autocorrelation patterns in stock returns.The speed of adjustment hypothesis
nds considerable support in the data (viz. BJSand Chordia and Swaminathan (2000)).
However, the hypothesis permits multiple dy-namic mechanisms. Speci
cally, di
erential speeds of adjustment could arise becauseof lags in transmission of common information, imperfect arbitrage across large andsmall stocks due to market frictions, or lags in transmission of informationless demandshocks with a systematic component. In this paper, we develop a simple model for cross-
Other important explanations have been proposed for lead and lag patterns. The cross-autocorrelations may be a result of non-synchronous trading; the idea being that the information thathas already been impounded into prices of large
rms is incorporated into small
rms’ prices only whenthey trade, which due to thin trading would, on average, occur with a lag. Another set of explanationssuggests that the cross-autocorrelations are a restatement of portfolio autocorrelation and contempora-neous correlations (Boudoukh, Richardson and Whitelaw (1994) and Hameed (1997)). Yet another setof explanations suggests that the predictability of small
rm returns could arise due to time-varying riskpremia (Conrad and Kaul (1988)). LM as well as McQueen, Pinegar, and Morley (1996) argue thatthese explanations are able to account partially, but not fully, for cross-autocorrelations.
See also Badrinath, Kale, and Noe (1995), Connolly and Stivers (1997) and Hou (2007).

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