MARKET MICROSTRUCTURE AND STOCK RETURN PREDICTIONS

To what extent are the empirical regularities implied by market micros tructure theories useful in predicting the short-run behavior of stock returns? A two-equation econometric model of quote revisions and tran saction returns is developed and used to identify the relative importa nce of different microstructure theories and to make predictions. Micr ostructure variables and lagged stock index futures returns have in-sa mple and out-of-sample predictive power based on data observed at five -minute intervals. The most striking microstructure implication of the model, confirmed by the empirical results, specifies that the expecte d quote return is positively related to the deviation between the tran saction price and the quote midpoint while the expected transaction re turn is negatively related to the same variable.