Information shocks and the cross section of expected returns

Abstract

This paper examines the risk premium associated with information shocks in equity markets. For all stocks traded on Borsa Istanbul between March 2005 and December 2020, we calculate information shocks as unanticipated information asymmetry by focusing on changes in the proportion of the effective spread attributable to adverse selection. Our results indicate a significant return premium for an information shock strategy. Specifically, the return premium associated with the zero-investment information shock portfolios is 72 basis points. After controlling for several factors, we then document a significant predictive relationship between information shocks and future returns. The predictive power and the return premium associated with the information shock strategy are stronger after the initiation of the BISTECH trading system, which enables heterogeneity across investors vis-à-vis trade execution latency. These results suggest that, after the introduction of fast trading, the risks associated with information shocks become systemically important in the cost of equity.