Market Microstructure and Nonlinear Dynamics by Gilles Dufrénot Fredj Jawadi & Waël Louhichi

Author:Gilles Dufrénot, Fredj Jawadi & Waël Louhichi
Language: eng
Format: epub
Publisher: Springer International Publishing, Cham

4.3 Order Imbalance and the Volume-Volatility Relation

Finally, this study examines the role of order imbalance in explaining the volume-volatility relation. Order imbalance is defined as the difference between the number of buyer-initiated transactions and the number of seller-initiated transactions over a trading day. Following Chan and Fong (2000), Eq. (1) is modified to include order imbalance as one of the regressors. The regression model is specified as follows:

(8)

where OIB it is the order imbalance for firm i on day t. This regression is motivated by trade indicator models, such as that of Huang and Stoll (1997), where price movements are caused by the net initiated order flow. Since Eq. (8) takes into consideration the impact of order imbalance on returns, Chan and Fong (2000) suggest the use of the absolute residual estimated from Eq. (8) as the proxy for price volatility when analyzing the volume-volatility relation, as in Eq. (3). If the daily order imbalance plays a vital role in the volume-volatility relation, as suggested by Chan and Fong (2000), the volume-volatility relation should be much weaker after controlling for the impact of order imbalance on daily returns. In other words, the volume-volatility relation revealed by using the absolute value of the residuals, estimated from Eq. (8) should be weaker than the volume-volatility relation revealed by using the absolute value of the residuals, estimated from Eq. (1).

Since price impact may vary across trade of different sizes, the order imbalance for each of the five different trade sizes discussed previously are also calculated. The role of the order imbalance of the different trade size categories in the volume-volatility relation is then examined in a similar manner to that of daily order imbalance. Specifically, Eq. (1) is modified to include the order imbalance of five different trade size categories as one of the regressors. The regression is specified as follows:

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