The Informedness Effect and Volume of Trade

Theoretical models of trade (Dontoh and Ronen, 1993; Holthausen and Verrecchia, 1990; Karpoff, 1986; Kim and Verrecchia, 1997; and Varian, 1989) show that information-based trading is a consequence of four fundamental determinants: heterogeneous prior beliefs, differential interpretations, the consensus effect, and the informedness effect. Although the effects of these determinants on trading volume are clear theoretically, there is no prior empirical evidence on the relation between the informedness effect and the volume of trade, nor is there any empirical evidence on the incremental effect of each of the four determinants on the volume of trade. This study provides empirical evidence to fill this void. Consistent with theoretical predictions in Holthausen and Verrecchia (1990), we find a significantly positive relation between the informedness effect and trading volume reactions to quarterly earnings announcements. We also find that the proxies for each of the four fundamental determinants of trading volume – prior belief heterogeneity, differential interpretation, the consensus effect, and the informedness effect of quarterly earnings signals – play a significant incremental role in explaining trading volume, thereby corroborating the theoretical results of financial economists. An important implication of our results is that empirical models of trade should consider controlling for each of these determinants