Order Flow Volatility and Equity Costs of Capital

We uncover a new determinant of equity costs of capital. Specifically, we show that levels of and shocks to order flow volatility are positively and significantly correlated with existing illiquidity proxies, and strongly predict stock returns in the cross section. The impact of such shocks on stock prices is reflected within one month in large, visible stocks, but takes over six months to be fully reflected in small, “neglected” stocks. We interpret order flow volatility as proxying for costs of information asymmetry, as order flow volatility varies positively with parameters that also influence adverse selection costs of trading.