Information Revelation in Financial Markets: Impulse Response Functions for Cointegrated Spreads and Depths

We investigate the path through which an information or liquidity shock reveals itself in subsequent adjustments of the bid-ask spreads and corresponding depths. Our simple threeequation error correction model incorporates both the short term and long term effects of the spread and depths on the dynamics of adjustment. In particular, we study both the stochastic properties of spreads and depths as well as their permanent impounding of stochastic common trends. Using two years of tick-by-tick quote data on all the DJIA stocks, we show that indeed depths rather than spreads are first to impound new information. Specifically, (bid and ask) depths adjust first in virtually every stock in both years, while spreads almost never adjust first in 1998, and do so in only 8 out of 30 cases in 1995. Analysis of the orthoganalized impulse response functions shows that spreads widen initially in response to positive depth shocks but that subsequent tightening occurs within 2 minutes and is a permanent effect. Depths decline in response to positive shocks to the spread but this effect is not permanent. In addition, bid depths and ask depths respond to one another in asymmetrical ways. Our results have important implications for testing competing theories of asymmetric information trading, for security market design, and for public policy. JEL Classification: G12