Strategic Cross-Trading in the U.S. Stock Market

Abstract

We provide a theory and novel empirical evidence of cross-price impact -- the permanent impact of informed trades in one asset on the prices of other (either related or fundamentally unrelated) assets -- in the U.S. stock market. To guide our analysis, we develop a parsimonious model of multi-asset trading in the presence of two realistic market frictions -- information heterogeneity and imperfect competition among informed traders -- but in which extant channels of trade and price co-formation in the literature are ruled out by construction. In that setting, we show cross-price impact to be the equilibrium outcome of strategic trading activity of risk-neutral speculators across many assets to mask their information advantage about some other assets. We find strong evidence of cross-asset informational effects in a comprehensive sample of the trading activity in NYSE and NASDAQ stocks between 1993 and 2004: Net order flow in one industry or random stock has a significant, persistent, and robust impact on daily returns of other industries or random stocks. Our empirical analysis further indicates that, consistent with our stylized model, both direct (i.e., an asset's own) and absolute cross-price impact are i) smaller when speculators are more numerous; ii) greater when marketwide dispersion of beliefs is higher; iii) greater among stocks dealt by the same specialist; and iv) smaller when macroeconomic news of good quality is released.