Liquidity in the Foreign Exchange Market: Measurement,Commonality, and Risk Premiums

We provide the first systematic study of liquidity in the foreign exchange market. We find significant variation in liquidity across exchange rates, substantial illiquidity costs, and strong commonality in liquidity across currencies and with equity and bond markets. Analyzing the impact of liquidity risk on carry trades, we show that funding (investment) currencies offer insurance against (exposure to) liquidity risk. A liquidity risk factor has a strong impact on carry trade returns from 2007 to 2009, suggesting that liquidity risk is priced. We present evidence that liquidity spirals may trigger these findings.     

The world price of liquidity risk

This paper empirically tests the liquidity-adjusted capital asset pricing model of Acharya and Pedersen (2005) on a global level. Consistent with the model, I find evidence that liquidity risks are priced independently of market risk in international financial markets. That is, a security’s required rate of return depends on the covariance of its own liquidity with aggregate local market liquidity, as well as the covariance of its own liquidity with local and global market returns. I also show that the US market is an important driving force of global liquidity risk. Furthermore, I find that the pricing of liquidity risk varies across countries according to geographic, economic, and political environments. The findings show that the systematic dimension of liquidity provides implications for international portfolio diversification.     

The pricing of systematic liquidity risk: Empirical evidence from the US stock market

In this study, we examine whether aggregate market liquidity risk is priced in the US stock market. We define a bivariate Garch (1,1)-in-mean specification for the market portfolio excess returns and the changes in the standardized number of shares in the S&P 500 Index, the aggregate market liquidity proxy. The findings, based on monthly data, suggest that systematic liquidity risk is priced in the US over the period January 1973–December 1997. The liquidity premium represents a non-negligible, negative and time-varying component of the total market risk premium whose magnitude is not influenced by the October’87 Crash.     

Global liquidity risk in the foreign exchange market

Using a broad data set of 20 US dollar exchange rates and order flow of institutional investors over 14 years, we construct a measure of global liquidity risk in the foreign exchange (FX) market. Our FX liquidity measure may be seen as the analog of the well-known Pastor–Stambaugh liquidity measure for the US stock market. We show that this measure has reasonable properties, and that there is a strong common component in liquidity across currencies. Finally, we provide evidence that liquidity risk is priced in the cross-section of currency returns, and estimate the liquidity risk premium in the FX market around 4.7 percent per annum.     

The asset pricing effects of UK market liquidity shocks: Evidence from tick data

Using tick data covering a 12 year period including much of the recent financial crisis we provide an unprecedented examination of the relationship between liquidity and stock returns in the UK market. Previous research on liquidity using high frequency data omits the recent financial crisis and is focused on the US, which has a different market structure to the UK. We first construct several microstructure liquidity measures for FTSE All Share stocks, demonstrating that tick data reveal patterns in intra-day liquidity not observable with lower frequency daily data. Our asymptotic principal component analysis captures commonality in liquidity across stocks to construct systematic market liquidity factors. We find that cross-sectional differences in returns exist across portfolios sorted by liquidity risk. These are strongly robust to market, size and value risk. The inclusion of a momentum factor partially explains some of the liquidity premia but they remain statistically significant. However, during the crisis period a long liquidity risk strategy experiences significantly negative alphas.     

Pricing of time-varying liquidity risk in Finnish stock market: new evidence

Using two recently developed illiquidity measures, we estimate a conditional version of liquidity-adjusted capital asset pricing model (LCAPM), which allows for a time-varying decomposition of the total illiquidity premium into a level component and three risk components. The total estimated annualized illiquidity premium for the Finnish equities during 1997–2015 is 1.13–1.90% depending on the illiquidity measure. Of the three systematic liquidity risk components, risk arising from hedging of wealth shocks is the most important followed by commonality in liquidity risk, whereas flight to liquidity risk is not significantly priced in the Finnish stock market. Our results show that the liquidity risk is time varying, therefore the models estimating the risk-return relationship should address the issue of conditionality.     

Pricing of liquidity risks: Evidence from multiple liquidity measures

We investigate the pricing implication of liquidity risks in the liquidity-adjusted capital asset pricing model of Acharya and Pedersen (2005), using multiple liquidity measures and their principal component. While we find that the empirical results are sensitive to the liquidity measure used in the test, we find strong evidence of pricing of liquidity risks when we estimate liquidity risks based on the first principal component across eight measures of liquidity, both in the cross-sectional and factor-model regressions. Our finding implies that the systematic component measured by each liquidity proxy is correlated across measures and the shocks to the systematic and common component of liquidity are an undiversifiable source of risk.     

Liquidity risk and stock returns around the world

The recent global financial crisis demonstrates that market liquidity is a prominent systematic risk globally. We find that local liquidity risk, in addition to the local market, value and size factors, demands a systematic premium across stocks in 11 developed markets. This local pricing premium is smaller in countries where the country-level corporate boards are more effective and where there are less insider trading activities. We also discover that global liquidity risk is a significant pricing factor across all developed country market portfolios after controlling for global market, value, and size factors. The contribution of this risk to the return on a country market portfolio is economically and statistically significant within and across regions.     

Liquidity and Expected Returns: Lessons from Emerging Markets

Given the cross-sectional and temporal variation in their liquidity,emerging equity markets provide an ideal setting to examinethe impact of liquidity on expected returns. Our main liquiditymeasure is a transformation of the proportion of zero dailyfirm returns, averaged over the month. We find that it significantlypredicts future returns, whereas alternative measures such asturnover do not. Consistent with liquidity being a priced factor,unexpected liquidity shocks are positively correlated with contemporaneousreturn shocks and negatively correlated with shocks to the dividendyield. We consider a simple asset-pricing model with liquidityand the market portfolio as risk factors and transaction coststhat are proportional to liquidity. The model differentiatesbetween integrated and segmented countries and time periods.Our results suggest that local market liquidity is an importantdriver of expected returns in emerging markets, and that theliberalization process has not fully eliminated its impact.     

Noise as Information for Illiquidity

We propose a market‐wide liquidity measure by exploiting the connection between the amount of arbitrage capital in the market and observed “noise” in U.S. Treasury bonds—the shortage of arbitrage capital allows yields to deviate more freely from the curve, resulting in more noise in prices. Our noise measure captures episodes of liquidity crises of different origins across the financial market, providing information beyond existing liquidity proxies. Moreover, as a priced risk factor, it helps to explain cross‐sectional returns on hedge funds and currency carry trades, both known to be sensitive to the general liquidity conditions of the market.     

Corporate Yield Spreads and Bond Liquidity

We find that liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4,000 corporate bonds and spanning both investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads, and an improvement in liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond‐specific, firm‐specific, and macroeconomic variables, and are robust to issuers' fixed effect and potential endogeneity bias. Our findings justify the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants.     

A Multifactor Model of Credit Spreads

We represent credit spreads across ratings as a function of common unobservable factors of the Vasicek form. Using a state-space approach we estimate the factors, their process parameters, and the exposure of each observed credit spread series to each factor. We find that most of the systematic variation across credit spreads is captured by three factors. The factors are closely related to the implied volatility index (VIX), the long bond rate, and S&P500 returns, supporting the predictions of structural models of default at an aggregate level. By making no prior assumption about the determinants of yield spread dynamics, our study provides an original and independent test of theory. The results also contribute to the current debate about the role of liquidity in corporate yield spreads. While recent empirical literature shows that the level and time-variation in corporate yield spreads is driven primarily by a systematic liquidity risk factor, we find that the three most important drivers of yield spread levels relate to macroeconomic variables. This suggests that if credit spread levels do contain a large liquidity premium, the time variation of this premium is likely driven by the same factors as default risk.     

The Epstein–Zin Model with Liquidity Extension

In this paper, we extend the Epstein–Zin model with liquidity risk and assess the extended model's performance against the traditional consumption pricing models. We show that liquidity is a significant risk factor, and it adds considerable explanatory power to the model. The liquidity‐extended model produces both a higher cross‐sectional R² and a smaller Hansen and Jagannathan distance than the traditional consumption‐based capital‐asset pricing model and the original Epstein–Zin model. Overall, we show that liquidity is both a priced factor and a key contributor to the extended Epstein–Zin model's goodness‐of‐fit.     

Sell-order liquidity and the cross-section of expected stock returns

We estimate buy- and sell-order illiquidity measures (lambdas) for a comprehensive sample of NYSE stocks. We show that sell-order liquidity is priced more strongly than buy-order liquidity in the cross-section of equity returns. Indeed, our analysis indicates that the liquidity premium in equities emanates predominantly from the sell-order side. We also find that the average difference between sell and buy lambdas is generally positive throughout our sample period. Both buy and sell lambdas are significantly positively correlated with measures of funding liquidity such as the TED spread as well option implied volatility.     

Momentum and post-earnings-announcement drift anomalies: The role of liquidity risk

This paper investigates the components of liquidity risk that are important for understanding asset-pricing anomalies. Firm-level liquidity is decomposed into variable and fixed price effects and estimated using intraday data for the period 1983–2001. Unexpected systematic (market-wide) variations of the variable component rather than the fixed component of liquidity are shown to be priced within the context of momentum and post-earnings-announcement drift (PEAD) portfolio returns. As the variable component is typically associated with private information [e.g., Kyle, 1985. Econometrica 53, 1315–1335], the results suggest that a substantial part of momentum and PEAD returns can be viewed as compensation for the unexpected variations in the aggregate ratio of informed traders to noise traders.     

RISK, SEASONALITY AND THE ASYMMETRIC BEHAVIOUR OF STOCK RETURNS

For some time there has been a puzzle surrounding the seasonal behaviour of stock returns. This paper demonstrates that there is an asymmetric relationship between systematic risk and return across the different months of the year for both large and small firms. In the case of both large and small firms systematic risk appears to be priced in only two months of the year, January and April. During the other months no persistent relationship between systematic risk and return appears to exist. The paper also shows that when systematic risk is priced, the size of the systematic risk premium is higher for large firms than for small firms and varies significantly across the months of the year.     

Measuring the liquidity impact on EMU government bond prices

Abstract

The work reported in this paper aimed to measure the impact of liquidity on European Monetary Union (EMU) government bond prices. Although there is a growing theoretical and empirical literature on liquidity effects in fixed income markets there is no clear answer to the questions how to measure liquidity and whether liquidity is priced in the market at all. The empirical analysis here is based on a unique data set containing individual bond data from six major EMU government bond markets, allowing one to compare yield curves estimated for subportfolios formed with respect to different potential liquidity measures. In a second procedure, liquidity measures are collected on the individual bond level and estimated pricing errors, given some reference yield curve, are regressed against these liquidity variables. This enables the conduction of formal tests on the pricing impact of liquidity measures. Results indicate that the benchmark property and the number of contributors are the most promising liquidity proxies having significant results in most countries. The results do not support the hypothesis that other liquidity measures under consideration, such as the on-the-run property, the issue size, and bid–ask spread related measures have a persistent price impact. A cross-country analysis of the subportfolio level indicates that liquidity effects cannot explain the size of the yield spreads between different issuers. This implies that effects other than liquidity, such as credit risk, are important driving factors of cross-country yield spreads.     

Spot rates,forward rates and exchange market efficiency

This paper examines the relationship between forward exchange rates and subsequently observed spot rates. No evidence is found for a liquidity premium on forward exchange, indicating that the forward rate can be used as a proxy of the market's expectations and that open exchange positions involve little systematic risk. It is also shown that forward exhange is priced as if the exchange rate could be characterized by a diffusion process with a trend, although there is some evidence such a process does not adequately characterize the exchange rate in all cases.     

Comparing possible proxies of corporate bond liquidity

We consider nine different proxies (issued amount, listed, euro, on-the-run, age, missing prices, yield volatility, number of contributors and yield dispersion) to measure corporate bond liquidity and use a four-variable model to control for interest rate risk, credit risk, maturity and rating differences between bonds. The null hypothesis that liquidity risk is not priced in our data set of euro corporate bonds is rejected for eight out of nine liquidity proxies. We find significant liquidity premia, ranging from 13 to 23 basis points. A comparison test between liquidity proxies shows limited differences between the proxies.     

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.