DP5604 Marketwide Private Information in Stocks: Forecasting Currency Returns

Author(s): Rui Albuquerque, Eva de Francisco, Luis Marques
Publication Date: March 2006
Keyword(s): currency returns, equity returns, firm-specific private information, marketwide private information, order flow, principal components
JEL(s): F31, G11, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5604

We present a model of equity trading with informed and uninformed investors where informed investors act upon firm-specific private information and marketwide private information. The model is used to structurally identify the component of order flow that is due to marketwide private information. Trades driven by marketwide private information display very little or no correlation with the first principal component of order flow. This finding implies that a simple statistical factor is a poor measure of marketwide private information. Moreover, the model suggests that the previously documented comovement in order flow captures mostly common variation in liquidity trades. We find that marketwide private information obtained from equity market data forecasts industry stock returns and foreign exchange returns consistent with Evans and Lyons' (2004a) model of exchange rate determination.