Information Asymmetry and Momentum Anomalies

Abstract

In this paper, we construct an information asymmetry factor (VECINF) based on the price discovery of large trades. VECINF is significantly negatively correlated with market excess return, indicating that market-wide information asymmetry is lower in bull markets, which is consistent with the view that more uninformed investors are attracted into stock markets when the markets offer high returns. In addition, VECINF has the most significant pricing effect among the considered risk factors (MKT, SMB, HML, and UMD), which suggests that ignoring the risk of information asymmetry may give rise to false discoveries of anomalies. As a case in point, we show that momentum anomalies disappear once we control for the risk of information asymmetry. This is because there are fewer informed traders, and hence lower risk of information asymmetry, in bad news firms (past losers or low earning surprise firms) than in good news firms (past winners or high earning surprise firms). The larger cost and risk of arbitrage in taking short positions makes bad news firms less attractive to informed traders. Consistent with this explanation, we find that the loading on VECINF is lower in bad news firms than in good news firms; and is lower only in the holding periods when momentum exists. This difference in loadings increases significantly with idiosyncratic volatility, and this explains why momentum is stronger in firms with large idiosyncratic volatility. Regardless of the level of idiosyncratic volatility, the significantly positive Fama-French factors risk-adjusted returns of zero investment momentum portfolios are no longer significant once we include VECINF as an additional factor for risk adjustment.