Information Efficiency and Firm-Specific Return Variation

Abstract

Reasoning that private firm-specific information causes firm-specific return variation that drives down market-model R 2 s, Morck, Yeung, and Yu (2000) begin a large body of research which interprets R 2 as an inverse measure of price informativeness. Low R 2 s or "synchronicity," as it is called in this literature, signal that prices more efficiently incorporate private firm-specific information, and high R 2 s indicate less. For this to be true, we would expect that low-R 2 stocks have characteristics that facilitate private informed trade, i.e. lower information costs and fewer impediments to arbitrage. However, in this paper we document the opposite: Low-R 2 stocks are small, young, and followed by few analysts, and have high bid-ask spreads, high price impact, greater short-sale constraints and are infrequently traded. In fact, microstructure measures suggest that private-information events are less likely for low-R 2 stocks than high, and that differences in R 2 are driven as much by firm-specific volatility on days without private news as by firm-specific volatility on days with private news. These results call into question prior research using R 2 to measure the information content of stock prices.

Stock price synchronicity and public firm-specificinformation

“…Coupled with other recent studies (e.g., Kelly, 2005), our results cast doubt on the validity of stock price synchronicity as a universal indicator of the quality of a firm's information environment.…”

“…Morck, Yeung, and Yu (2000), Jin and Myers (2006), and Haggard, Martin, and Pereira (2008) find that stock price synchronicity is negatively related to the quality of information environment, thereby suggesting that R 2 can be an inverse proxy for information quality. In sharp contrast, Kelly (2005) and Dasgupta, Gan, and Gao (forthcoming) show that stock price synchronicity is positively related to the quality of the information environment, implying that R 2 can be a direct proxy for this quality. Although both sides do not agree with each other, they both suggest that there is a monotonic (either positive or negative) relation between R 2 and the quality of the information environment.…”

Information efficiency changes following FTSE 100 index revisions

“…They argue that large trades exhibit a greater adverse selection effect as they are executed by better-informed investors. Kelly (2005) also shows that high idiosyncratic risk is associated with a poor information environment with greater noise trading, which causes stock prices to deviate from their fundamental values. However, Durnev et al (2003) find that firms and industries with greater idiosyncratic volatility display greater stock price informativeness.…”

On the computation of LOT liquidity measure

“…Therefore transaction costs can be regraded as the thresholds of security's daily return. Ever since its proposal, LOT measure has become a popular choice in financial empirical researches on liquidity, see for example, Lesmond et al (2004); Lesmond (2005); Kelly (2005); Ng et al (2008); Griffin et al (2010) and Naes et al (2011).…”