Shocks to Order Flow Volatility and Stock Returns

In theoretical models, liquidity and order flow volatility are determined by the same exogenous parameters. Thus, the variability of order flow can at least partially proxy for the unobserved (true) liquidity. Levels of and shocks to order flow volatility are indeed positively and 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 evidence indicates that 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