BV–VPIN: Measuring the impact of order flow toxicity and liquidity on international equity markets

Rand Low, Te Li and Terry Marsh

Journal of Risk

Abstract: Order flow toxicity is the measure of a trader’s exposure to the risk that counterparties possess private information or other informational advantages. High levels of order flow toxicity can culminate in market makers providing liquidity at a loss or in the suboptimal execution of trades. From a regulatory perspective, high levels of toxicity can be harmful to overall market liquidity and precede precipitous drops in asset prices. The bulk volume–volume-synchronized probability of informed trading (BV–VPIN) model is one way of measuring the “toxicity†component of order flow, and it has been successfully applied in high-frequency trading environments. We apply the BV–VPIN to daily data from a range of international indexes in order to extend previous analyses of its properties. We find that a rise in BV–VPIN effectively foreshadows high levels of volatility in the equity indexes of several countries. If a BV–VPIN futures;contract were to exist, we show that it would exhibit safe haven characteristics during market downturns. In particular, a simple active portfolio management strategy that times investments in equities (risk-free assets) when BV–VPIN levels are low (high) outperforms a buy-and-hold strategy. Thus, we find support for the application of BV–VPIN in international equity markets as a risk monitoring and management tool for portfolio managers and regulators.

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