Estimating Equity Price Impact and Its Link to Future Returns

Summary

The document studies whether daily equity order flow can reveal price impact and help forecast stock returns. It forms monthly signed-flow measures and estimates Kyle’s lambda using both a regression of price changes on order flow and an Amihud-style price-impact ratio. The sample covers U.S. stocks from 2020 through 2025.

Signed order flow is associated with returns in the same month and the following month, while more volatile trading volume is linked to weaker later returns. Cross-sectional Fama–MacBeth tests retain the order-flow relationship after Newey–West adjustment. The proposed explanation is that adverse selection makes low order flow coincide with wider price impact and lower prices; as conditions normalize, prices recover, creating a premium associated with illiquidity. The reported findings are specific to the sample period and observational measures, and the abstract does not establish that the signal is causal or profitable after trading costs.

Key ideas

• Signed order flow is tested as a predictor of subsequent cross-sectional stock returns.
• Price impact is estimated with a within-month regression and an Amihud-style ratio.
• Volume volatility is associated with lower subsequent returns in the reported sample.
• The paper attributes an illiquidity premium to adverse selection and later price recovery.
• The evidence comes from U.S. equities over 2020–2025 and uses adjusted Fama–MacBeth regressions.

Tags

# Liquidity Premium and Investment Horizons


# Liquidity Premium and Investment Horizons









We estimate Kyle's (1985) price-impact coefficient $λ$ directly from daily equity order flow and test its ability to forecast the cross-section of subsequent stock returns. Using CRSP data from 2020 to 2025, we construct firm-month measures of signed order flow and two estimators of $\hatλ_{it}$: a within-month price-impact regression and an Amihud-style ratio. Signed order flow strongly predicts contemporaneous and one-month-ahead returns, while volume volatility predicts lower subsequent returns, consistent with widening price impact degrading price discovery. Fama-MacBeth regressions confirm that our order-flow signal carries significant cross-sectional return information after Newey--West adjustment. Theoretically, we resolve the liquidity premium puzzle of Constantinides (1986) through an adverse-selection mechanism: low order flow widens $λ$ and depresses prices today; subsequent normalization restores prices, generating the illiquidity premium without risk-based compensation.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.