The Endogeneity of Trading Volume in Stock and Bond Returns: An Instrumental Variable Approach

Abstract

This paper investigates the joint determination of two dimensions of a security: trading volume and return. In much of the existing literature, volume is modeled as being exogenously related to security returns. Our analysis evaluates the extent to which trading activity also depends on security returns, thus resulting in a reverse causality from returns to trading activity. Using instruments for security trading activity, we compare approaches using ordinary least squares (OLS), two-stage least squares (2SLS), and generalized method of moment (GMM) estimators. Using both stock and bond data, our results indicate that returns and trading volume are determined simultaneously. We show that estimates of the magnitude, direction, and significance of causality between volume and returns can be substantially changed once one corrects for the endogeneity of volume.