Shocks to Order Flow Volatility and Stock Returns

In theoretical models, liquidity and order flow volatility are determined by the same exogenous parameters. Thus, order flow volatility can proxy for true (unobserved) liquidity. Levels of and shocks to order flow volatility are significantly correlated with existing illiquidity proxies. Shocks to order flow volatility strongly predict stock returns in the cross-section, even after accounting for risk factors, firm characteristics known to influence returns, and other liquidity measures. The impact of such shocks is reflected in stock prices within one month in large, visible stocks, but takes over six months to be fully reflected in small, neglected stocks.