Limit Order Book and Commonality in Liquidity

We show that the liquidity provided by an individual stock's limit order book comoves significantly with the market aggregate limit order book liquidity. A closer look at the inside and outside liquidity provided by different parts of limit order book suggests that inside liquidity is mainly influenced by market volatility, while idiosyncratic volatility has a larger impact on outside liquidity. Hence, limit order book inside liquidity exhibits higher commonality than outside liquidity. We also show that the comovement between the stock‐level and market‐aggregate limit order book liquidity measures is related to the commonality in the overall stock market liquidity.     

Option market liquidity: Commonality and other characteristics

This study examines option market liquidity using Ivy DB's OptionMetrics data. We establish convincing evidence of commonality for various liquidity measures based on the bid–ask spread, volumes, and price impact. The commonality remains strong even after controlling for the underlying stock market's liquidity and other liquidity determinants such as volatility. Smaller firms and firms with a higher volatility exhibit stronger commonalities in option liquidity. Aside from commonality, we also uncover several other important properties of the option market's liquidity. First, information asymmetry plays a much more dominant role than inventory risk as a fundamental driving force of liquidity. Second, the market-wide option liquidity is closely linked to the underlying stock market's movements. Specifically, the options liquidity responds asymmetrically to upward and downward market movements, with calls reacting more in up markets and puts reacting more in down markets.     

Reprint of: Market liquidity in the financial crisis: The role of liquidity commonality and flight-to-quality

We examine the dynamics and the drivers of market liquidity during the financial crisis, using a unique volume-weighted spread measure. According to the literature we find that market liquidity is impaired when stock markets decline, implying a positive relation between market and liquidity risk. Moreover, this relationship is the stronger the deeper one digs into the order book. Even more interestingly, this paper sheds further light on so far puzzling features of market liquidity: liquidity commonality and flight-to-quality. We show that liquidity commonality varies over time, increases during market downturns, peaks at major crisis events and becomes weaker the deeper we look into the limit order book. Consistent with recent theoretical models that argue for a spiral effect between the financial sector’s funding liquidity and an asset’s market liquidity, we find that funding liquidity tightness induces an increase in liquidity commonality which then leads to market-wide liquidity dry-ups. Therefore our findings corroborate the view that market liquidity can be a driving force for financial contagion. Finally, we show that there is a positive relationship between credit risk and liquidity risk, i.e., there is a spread between liquidity costs of high and low credit quality stocks, and that in times of increased market uncertainty the impact of credit risk on liquidity risk intensifies. This corroborates the existence of a flight-to-quality or flight-to-liquidity phenomenon also on the stock markets.     

Market liquidity in the financial crisis: The role of liquidity commonality and flight-to-quality

We examine the dynamics and the drivers of market liquidity during the financial crisis, using a unique volume-weighted spread measure. According to the literature we find that market liquidity is impaired when stock markets decline, implying a positive relation between market and liquidity risk. Moreover, this relationship is the stronger the deeper one digs into the order book. Even more interestingly, this paper sheds further light on so far puzzling features of market liquidity: liquidity commonality and flight-to-quality. We show that liquidity commonality varies over time, increases during market downturns, peaks at major crisis events and becomes weaker the deeper we look into the limit order book. Consistent with recent theoretical models that argue for a spiral effect between the financial sector’s funding liquidity and an asset’s market liquidity, we find that funding liquidity tightness induces an increase in liquidity commonality which then leads to market-wide liquidity dry-ups. Therefore our findings corroborate the view that market liquidity can be a driving force for financial contagion. Finally, we show that there is a positive relationship between credit risk and liquidity risk, i.e., there is a spread between liquidity costs of high and low credit quality stocks, and that in times of increased market uncertainty the impact of credit risk on liquidity risk intensifies. This corroborates the existence of a flight-to-quality or flight-to-liquidity phenomenon also on the stock markets.     

COMMONALITY IN LIQUIDITY OF NEARBY FIRMS

In this article, we examine commonality in liquidity of firms headquartered in the same states and how the local liquidity commonality is influenced by firm‐ and state‐level characteristics. We document strong liquidity comovement of nearby firms. Moreover, firms that change headquarters location experience a decrease in their liquidity commonality with firms in the old states and an increase in their liquidity commonality with firms in the new states. Our findings show that both firm‐ and state‐level characteristics determine local liquidity comovement. Local liquidity commonality is stronger for firms with smaller size and lower level of institutional ownership. Our results also suggest that state‐level volatility, state personal income, state investment income, and state turnover commonality explain the local component of liquidity commonality. We further document that the four state‐level factors perform differently during volatile market periods.     

The intraday behaviors and relationships with its underlying assets: evidence on option market in Taiwan

In this paper, we use daily data to investigate the information asymmetric effects and the relationships between the trading volume of options and their underlying spot trading volume. Our results reveal that options with higher liquidity are near-the-money and expiration periods with 2 to 4 weeks have higher trading activity. We classify them into two parts with the ARIMA model: the expected trading activity impact and the unexpected trading activity impact. Using the bivariate generalized autoregressive conditional heteroscedasticity (GARCH) model, we investigate the trading activity effect and information asymmetric effect. In conclusion, the trading volume volatility of the spot and options markets move together, and a greater expected and unexpected trading volume volatility of the spot (options) market is associated with greater volatility in the options (spot) market. However, both markets generate higher trading volume volatility when people expect such an impact rather than when they do not. We also find that there are feedback effects within these two markets. Furthermore, when the spot (options) market has negative innovations, it generates a greater impact on the options (spot) market than do positive innovations. Finally, the conditional correlation coefficient between the spot and the option markets changes over time based on the bivariate GARCH model.     

Measuring liquidity commonality in financial markets

This paper contributes to the literature by developing a new methodology, termed the beta index, for measuring liquidity commonality in financial markets which is derived from the dynamics of liquidity co-movements. We show that computing the beta index is a straightforward process. In addition, not only is the proposed beta index more efficient in controlling for confounding factors and addressing the associated statistical inference issues, but it will also enhance the accuracy of estimation. We apply the beta index to track liquidity commonality in the foreign exchange markets over the study period and to identify important financial and economic events that caused liquidity commonality. We detect periods of high and low liquidity commonalities that would especially benefit active market traders who frequently rebalance portfolios and require knowledge of liquidity commonality as an important early signal and indication of diversification benefit.     

Return and volatility co-movement in commodity futures markets: the effects of liquidity risk

Commodity markets are a widely researched topic in the field of finance. In this paper, we investigate the co-movement of return and volatility measures in different commodity futures markets and how these measures are affected by liquidity risk. First, we find that commodity returns display co-movement and that liquidity risk plays a key role in shaping asset return patterns. Moreover, we show that the volatilities of commodity returns co-move, and we demonstrate the role of liquidity risk in this joint pattern. We also find that the commodity markets we investigated share a common volatility factor that determines their joint volatility co-movement. Because liquidity risk affects both commodity returns and volatility shocks, it might be interpreted as the common causal factor driving both measures simultaneously. Therefore, we affirm the view that liquidity shocks are firmly related to two residual risks originating from both market return and market volatility. Finally, we also show that liquidity spillovers can significantly drive cross-sectional correlation dynamics.     

Commonality in liquidity: Evidence from the Australian Stock Exchange

Several studies have reported strong evidence of commonality in liquidity in US markets. The present study uses the research design of Chordia et al. (2000) to examine commonality in liquidity for a broad sample of stocks listed on the Australian Stock Exchange (ASX). In contrast to previous research, there is some evidence of market‐wide commonality in liquidity for ASX stocks, but it is less significant and less pervasive than that observed in other markets. These results are consistent with explanations based on differences in market structure between the USA and Australia.     

LIQUIDITY COMMONALITY BEYOND BEST PRICES

Previous market microstructure research focuses on commonality in liquidity at the inside spread. However, liquidity at the inside spread only determines the systematic liquidity risk of small and medium trades. We study commonality in displayed liquidity beyond best prices, which determines the systematic liquidity risk of large trades. We show that it is much larger than commonality at the inside spread. The deeper we look into the order book, the higher is the level of commonality. In addition, it rises in the morning and when markets fall.     

Commonality on Euronext: Do location and account type matter?

Using a rich dataset of orders and trades for a sample of stocks listed on four Euronext markets, we apply principal component analysis and provide evidence on the existence and magnitude of commonality in returns, order flow and liquidity. We show that commonality in order flow mainly comes from foreign market members acting for their own account. Proprietary trading is a major driver in trade imbalance and return commonality. Next, we provide evidence on commonality in hidden liquidity. In contrast to commonality in visible depth that is the strongest for large firms, comovements in hidden depth seem to be stronger for small caps. We also show that commonality in returns, order flow and liquidity is not constant throughout the day. The opening of US markets is a key moment where commonality often reaches its maximum level. These findings suggest that most of the commonality is driven by foreigners, generating an increase in systematic liquidity risk, due to foreigners' similar trading behaviors, whose importance evolves throughout the day.     

Liquidity dynamics across public and private markets

In this paper we investigate cross-asset liquidity between equity markets and REITs and between REITs and private real estate markets. While many studies have investigated REIT liquidity, and there is an emerging interest in liquidity in the private real estate markets, there appears to be little knowledge of the dynamics of cross-market liquidity. We find lower levels of liquidity for REITs compared to a set of control firms matched on size and book-to-market ratios. Commonality in liquidity is also lower for REITs than the controls and the overall market. However, we do find an important difference in share turnover for REITs, which appears to have a higher level of commonality than found in other studies. We suggest that this may be due to the financial crisis. Additionally we find evidence of similar time-series variation in liquidity for public and private real estate markets. We also find significant directional causality for most liquidity proxies from the public to private real estate markets. Finally our results show that there is strong contemporaneous correlation between both public and private real estate market liquidity and the term spread and real investment and consumption spending. REIT liquidity measures based on intraday data also appear to contain important information not found in measures constructed from daily returns.     

Liquidity Provision of Limit Order Trading in the Futures Market Under Bull and Bear Markets

Abstract:  This study investigates how limit orders affect liquidity in a purely order-driven futures market. Additionally, the possible asymmetric relationship between market depth and transitory volatility in bull and bear markets and the effect of institutional trading on liquidity provision behavior are examined as well. The empirical results demonstrate that subsequent market depth increases as transient volatility increases in bull markets. Market depth exhibits significantly positive relationship to subsequent transient volatility in bull markets. Additionally, although trading volume positively influences transient volatility in bull markets, no such relationship exists in bear markets. Liquidity provision decreases when institutional trading activity intensifies during bear markets. Thus, liquidity provision for limit orders differs between bull and bear markets.     

Determinants of idiosyncratic volatility: Evidence from the Indian stock market

This paper investigates whether firm-specific characteristics explain idiosyncratic volatility in the stocks of non-financial firms traded in the Indian stock market. It employs the linear time series five-factor model, augmented with a liquidity factor and the conditional EGARCH model, to extract yearly idiosyncratic volatility. We estimate a panel data regression to quantify the relationship between firm-specific characteristics and the volatility of individual securities. The results show that idiosyncratic volatility is significant in emerging markets such as India, and that cross-sectional return variations of firms are associated with firm-specific characteristics such as firm size, book-to-market ratio, momentum, liquidity, cash flow-to-price ratio, and returns on assets. We find that the idiosyncratic risk documented in this study is associated with smaller size of company, higher liquidity, low momentum, high book-to-market ratio, and low cash flow-to-price ratio. The findings suggest need to develop alternative tools to make investment decisions in emerging markets.     

Liquidity commonality in commodities

We examine liquidity commonality in commodity futures markets. Using data from 16 agricultural, energy, industrial metal, precious metal, and livestock commodities, we show there is a strong systematic liquidity factor in commodities. Liquidity commonality was present in 1997–2003 when commodity prices were relatively stable and during the recent boom. There is some support for both “supply-side” and “demand-side” explanations for this commonality. We find no evidence of a consistent link between stock and commodity liquidity in general. Energy commodities appear to provide a better hedge against equity market liquidity risk than the other commodity families.     

Dynamic relationship between exchange rate and stock price: Evidence from China

The paper empirically analyzes the dynamic relationship between Renminbi (RMB) real effective exchange rate and stock price with VAR and multivariate generalized autoregressive conditional heteroskedasticity (GARCH) models using monthly data from January 1991 to June 2009. The results show that there is not a stable long-term equilibrium relationship between RMB real effective exchange rate and stock price. There are also not mean spillovers between the foreign exchange and stock markets. Furthermore, the paper examines the cross-volatility effects between foreign exchange and stock markets using likelihood ratio statistic. There exist the bidirection volatility spillovers effects between the two markets, indicating the past innovations in stock market have the great effect on future volatility in foreign exchange market, and vice versa.     

Commonality in equity options liquidity: evidence from European Markets

This paper examines commonality in liquidity for individual equity options trading in European markets. We use high-frequency data to construct a novel index of liquidity commonality. The approach is able to explain a substantial proportion of the liquidity variation across individual options. The explanatory power of the common liquidity factor is more pronounced during periods of higher market-wide implied volatility. The common factor's impact on individual options' liquidity depends on options' idiosyncratic characteristics. There is some evidence of systematic liquidity spillover effects across these European exchanges.     

The intraday determination of liquidity in the NYSE LIFFE equity option markets

We exploit an extensive high-frequency data set of all individual equity options trading at New York Stock Exchange London International Financial Futures and Options Exchange (Amsterdam, London and Paris) in order to study the determination of liquidity during the trading day. In particular, we focus on two main aspects of option liquidity: (i) the intraday behaviour of equity option liquidity and its determinants and (ii) the influence of macroeconomic events and commonality on intraday equity option liquidity. Inventory management models cannot explain the intraday variation in option spreads and depths. Instead, we show that the option liquidity measures are strongly correlated with option volatility. Increases in volatility are associated with decreases in liquidity, a finding that is in line with information asymmetry models and the derivatives hedging theory. However, the relationship between spreads and volume varies across the three markets. Option liquidity reacts strongly to macroeconomic news announcements, especially US events. The average systematic liquidity component is 12% for Amsterdam, 14% for London and 16% for Paris.     

Stock Market Declines and Liquidity

Consistent with recent theoretical models where binding capital constraints lead to sudden liquidity dry-ups, we find that negative market returns decrease stock liquidity, especially during times of tightness in the funding market. The asymmetric effect of changes in aggregate asset values on liquidity and commonality in liquidity cannot be fully explained by changes in demand for liquidity or volatility effects. We document interindustry spillover effects in liquidity, which are likely to arise from capital constraints in the market making sector. We also find economically significant returns to supplying liquidity following periods of large drops in market valuations.     

Common liquidity shocks and market collapse: Lessons from the market for perps

We show how a high degree of commonality in investor liquidity shocks can diminish incentives for intermediaries to keep markets open and lead to market collapse, even without information asymmetry or news affecting fundamentals. We motivate our model using the perpetual floating-rate note market where two years of explosive growth – in which issues by high quality borrowers were placed with institutional investors and traded in a liquid secondary market – were followed by a precipitous collapse when market intermediaries withdrew due to large order imbalances. We shed new light on the trade-off between ownership concentration and market liquidity.