Information Asymmetry and Investment-Cash Flow Sensitivity

Bryant University, Department of Finance, United States
Journal of Banking & Finance (Impact Factor: 1.29). 06/2008; 32(6):1036-1048. DOI: 10.1016/j.jbankfin.2007.09.018
Source: RePEc


Models of capital market imperfections predict that information asymmetry decreases firm investment and increases the sensitivity of investment expenditures to fluctuations in internal funds. Previous empirical tests of the link between investment and financing decisions have relied on indirect measures of financial constraint due to market frictions. In contrast, we use more direct measures derived from the market microstructure literature. Consistent with the theoretical predictions, our analysis shows that scaled investment expenditures are on average lower and the investment–cash flow sensitivity is greater when the probability of informed trading is high. Our results are robust to alternative measures of informed trading and liquidity, but they are not pervasive in our sample.

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Available from: John B. Mcdermott, Dec 17, 2014
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    • "The Q-Method can mitigate estimation biases for both the PIN Model and its extensions. Moreover, the PIN has been widely employed in securities market studies (e.g., [3]-[7]). "

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    • "In addition, we further investigate the alternative explanation that the pricing impact of VECIN is simply a result of mispricing. Hirshleifer and Jiang (2010) use equity and debt financing to identify common mispricing across firms and construct a mispricing announcement drift (Vega (2006)), and firm investment and its sensitivity to cash flow (Chen, Goldstein and Jiang (2007) and Ascioglu, Hegde and McDermott (2008)), to list just a few examples. "
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    ABSTRACT: The price discovery function measures the private information revealed in prices through trades. As informed traders prefer large trades, the price discovery function of large trades (VECIN), estimated from a vector error correction model of cointegrated price series of large and small trades, measures the extent of information asymmetry between traders. VECIN has a strong impact on future stock returns, and its power to predict stock returns is stronger than any of the well-known return predictors we have considered. A VECIN spread portfolio of NYSE/Amex stocks that goes long in the top VECIN quintile and short in the bottom VECIN quintile earns a Fama-French (1993) risk-adjusted return of 0.99% per month. Adding the VECIN spread portfolio to the Fama-French three factors triples the Sharpe ratio of the ex-post tangency portfolio from 0.24 to 0.71. Further tests suggest that mispricing cannot fully explain the strong pricing impact of VECIN.
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