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The Informational Content of Transactions

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  • Karl Ludwig Keiber

Abstract

This paper studies the price discovery process in security markets. In particular, it analyzes the incorporation of information into security prices in a quote-driven security market from the perspective of information theory. In essence, it draws on a sequential trading mechanism, which is standard in market microstructure theory, and in which information is processed on the basis of individual transactions. It is demonstrated that the ex-ante information content of a transaction is proportionate to the average Kullback–Leibler distance of the prior and the posterior probability measures that quantify the uncertainty on the state of nature prior to and after that transaction, respectively. It is shown that the information on the state of nature, reflected in the security price, never decreases ex-ante by an upcoming transaction, which in turn accounts for the fact that the order flow is informationally valuable. Finally, it is pointed out that security markets in which the order flow is completely uninformative for the state of nature feature maximum depth; that is, those security markets are maximally liquid. Copyright Swiss Society for Financial Market Research 2005

Suggested Citation

  • Karl Ludwig Keiber, 2005. "The Informational Content of Transactions," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 19(1), pages 47-60, June.
    • Handle: RePEc:kap:fmktpm:v:19:y:2005:i:1:p:47-60
    DOI: 10.1007/s11408-005-2297-4
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    References listed on IDEAS

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    1. Stoll, Hans R, 1978. "The Supply of Dealer Services in Securities Markets," Journal of Finance, American Finance Association, vol. 33(4), pages 1133-1151, September.
    2. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
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    4. Lee, Charles M C & Ready, Mark J, 1991. "Inferring Trade Direction from Intraday Data," Journal of Finance, American Finance Association, vol. 46(2), pages 733-746, June.
    5. Grossman, Sanford J, 1976. "On the Efficiency of Competitive Stock Markets Where Trades Have Diverse Information," Journal of Finance, American Finance Association, vol. 31(2), pages 573-585, May.
    6. Ho, Thomas S Y & Stoll, Hans R, 1983. "The Dynamics of Dealer Markets under Competition," Journal of Finance, American Finance Association, vol. 38(4), pages 1053-1074, September.
    7. Easley, David & O'Hara, Maureen, 1991. "Order Form and Information in Securities Markets," Journal of Finance, American Finance Association, vol. 46(3), pages 905-927, July.
    8. Easley, David, et al, 1996. "Liquidity, Information, and Infrequently Traded Stocks," Journal of Finance, American Finance Association, vol. 51(4), pages 1405-1436, September.
    9. Diamond, Douglas W. & Verrecchia, Robert E., 1987. "Constraints on short-selling and asset price adjustment to private information," Journal of Financial Economics, Elsevier, vol. 18(2), pages 277-311, June.
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    Cited by:

    1. Héléna Beltran-Lopez & Pierre Giot & Joachim Grammig, 2009. "Commonalities in the order book," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 23(3), pages 209-242, September.

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