Pricing the commonality across alternative measures of liquidity

We estimate latent factor models of liquidity, aggregated across various liquidity measures. Shocks to assets’ liquidity have a common component across measures which accounts for most of the explained variation in individual liquidity measures. We find that across-measure systematic liquidity is a priced factor while within-measure systematic liquidity does not exhibit additional pricing information. Controlling for across-measure systematic liquidity risk, there is some evidence that liquidity, as a characteristic of assets, is priced in the cross-section. Our results are robust to the inclusion of other equity characteristics and risk factors, such as market capitalization, book-to-market, and momentum.     

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 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.     

Stock price synchronicity and liquidity

We argue and provide evidence that stock price synchronicity affects stock liquidity. Under the relative synchronicity hypothesis, higher return co-movement (i.e., higher systematic volatility relative to total volatility) improves liquidity. Under the absolute synchronicity hypothesis, stocks with higher systematic volatility or beta are more liquid. Our results support both hypotheses. We find all three illiquidity measures (effective proportional bid-ask spread, price impact measure, and Amihud's illiquidity measure) are negatively related to stock return co-movement and systematic volatility. Our analysis also shows that larger industry-wide component in returns improves liquidity. We find that improvement in liquidity following additions to the S&P 500 Index is related to the stock's increase in return co-movement.     

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.     

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.     

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.     

Interaction of credit and liquidity risks: Modelling and valuation

In this paper we discuss the interaction of default risk and liquidity risk on pricing financial contracts. We show that two risks are almost indistinguishable if the underlying contract has non-negative values; however, if it can take both positive and negative values then these two risks demand different risk premiums depending on their loss rates and distributions. We discuss a structural default model and a discrete time default model with exponentially distributed liquidity shocks. We show that short-term yield spreads are dominated by liquidity risk rather than credit risk. We suggest a two-stage procedure to calibrate the model with one scalar optimization problem and one linear programming problem.     

Asset market equilibrium with liquidity risk

This paper derives an equilibrium asset pricing model with endogenous liquidity risk. Liquidity risk is modeled as a stochastic quantity impact on the price from trading, where the size of the impact depends on trade size. Under a strong set of assumptions, we prove that a unique equilibrium liquidity cost process and a unique equilibrium price process exists for our economy. We characterize the market’s state price density, which enables the derivation of the risk-return relation for the stock’s expected return including liquidity risk. We derive a generalized intertemporal CAPM and consumption CAPM for these markets. In contrast to the traditional models without liquidity risk, there is an additional systematic liquidity risk factor which is related to the stock return’s covariation with the market’s stochastic liquidity cost. Traditional transaction costs are a special case of our formulation.     

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.     

Risk sentiment and firms’ liquidity in the French market

This paper investigates the impact of risk sentiment on market liquidity by using panel data. We use six risk word lists; uncertain, weak model, negative, legal, opportunity, and environmental & social responsibility word lists to measure the risk sentiment. Concerning the liquidity proxies, we use three measures, quoted spread, effective spread, and adverse selection component. The results indicate that an intensive risk tone and uncertain information in annual reports lead to decreased liquidity. In addition we find that risk sentiment variable impacts the liquidity but not vice versa.     

Earnings management and market liquidity

The main purpose of this paper is to argue the extent that earnings management lowers disclosure quality. It should increase information asymmetry and impair trading liquidity. Using a large sample of NYSE firms from 1996 to 2001, we find evidence to suggest that firms which exhibit greater earnings management are associated with lower market liquidity. Our results are robust to both real and accounting based measures of earnings management and two well established measures of market liquidity. However, they are not consistent with the Easley et al. probability of informed trade measure.     

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.     

Time-Varying Arrival Rates of Informed and Uninformed Trades

We propose a dynamic econometric microstructure model of trading,and we investigate how the dynamics of trades and trade compositioninteract with the evolution of market liquidity, market depth,and order flow. We estimate a bivariate generalized autoregressiveintensity process for the arrival rates of informed and uninformedtrades for 16 actively traded stocks over 15 years of transactiondata. Our results show that both informed and uninformed tradesare highly persistent, but that the uninformed arrival forecastsrespond negatively to past forecasts of the informed intensity.Our estimation generates daily conditional arrival rates ofinformed and uninformed trades, which we use to construct forecastsof the probability of information-based trade (PIN). These forecastsare used in turn to forecast market liquidity as measured bybid-ask spreads and the price impact of orders. We observe thatPINs vary across assets and over time, and most importantlythat they are correlated across assets. Our analysis shows thatone principal component explains much of the daily variationin PINs and that this systemic liquidity factor may be importantfor asset pricing. We also find that PINs tend to rise beforeearnings announcement days and decline afterwards.     

Disentangling types of liquidity and testing limits-to-arbitrage theories in the CDS–bond basis

We disentangle asset-specific, market, and funding liquidity in the CDS–bond basis outside and during the 2007–9 global financial crisis. Our findings stress the importance of separating different types of liquidity, since all three measures have independently negative impacts on the basis. Funding liquidity emerges as the economically most important liquidity metric. While asset-specific liquidity is cross-correlated in both the cash and derivative markets, funding and market liquidity only matter for the cash market. We exploit the decomposition of the basis to test predictions of limits-to-arbitrage theories. We find strong evidence in favor of margin-based asset pricing and flight-to-quality effects.     

Institutional ownership and commonality in liquidity

We investigate the relation between institutional ownership and commonality in liquidity and whether this relation differs across country-level institutional and information environments. Using a comprehensive dataset for firms across 40 countries for the period between 2000 and 2016, we find that institutional ownership is negatively associated with stock liquidity commonality. In addition, a firm’s information environment plays the moderating role in the relation between institutional ownership and commonality in stock liquidity. Importantly, we document that the negative association between institutional ownership and liquidity commonality is stronger for firms in countries with weak institutional characteristics or less transparent information environments. Our findings provide additional insights into the role of institutional investors as a demand-side factor of liquidity commonality in international financial markets.     

The role of governance on bank liquidity creation

This paper examines the impact of internal bank governance on bank liquidity creation in the U.S. before, during and after the 2007–2009 financial crisis. Using bank holding company level data, we analyze whether better-governed banks create higher levels of liquidity. We find that this effect is positive and significant but only for large bank holding companies. Further analysis reveals that specific internal governance categories: CEO education, compensation structure, progressive practices, and ownership have a significant effect on bank liquidity. However, this positive effect occurs mostly during the crisis period, and for large banks that are also high liquidity creators. Finally, we find that the effect of governance on liquidity creation increases during the crisis period. These findings are robust even while controlling for liquidity measures, bank size, and endogeneity problems between governance and liquidity creation.     

Investor strategies in the green bond market: The influence of liquidity risks,economic factors and clientele effects

The green bond market has dramatically expanded especially in Europe but severe liquidity issues may undermine its rapid development. If few studies have assessed the implied liquidity risks for investors in terms of liquidity premium, none of them have specifically analysed its behavior across bond maturities. To fill this gap, this paper studies the term structure of the liquidity premium of the green bond market.We find that the sizes of short-term and long-term premia are close to those estimated on the German government bond market. We show that those premia are affected by economic factors and by spillover effects between them, which contribute to the U-Shape of the liquidity premium. Finally, we detect a liquidity clientele effect on the ask side impacting the liquidity premium, which implies a maturity segmentation i.e., high-risk (resp. low-risk) investors buy short-term (resp. long-term) green bonds and hold them until maturity.Taken together, our results deliver valuable insights on investors' strategies in the green bond market. Quite importantly, green bond investors prefer to opt for buy and hold strategies because they are compensated for higher liquidity risks along the entire maturity spectrum.     

Economic valuation of liquidity timing

This paper conducts a horse-race of different liquidity proxies using dynamic asset allocation strategies to evaluate the short-horizon predictive ability of liquidity on monthly stock returns. We assess the economic value of the out-of-sample power of empirical models based on different liquidity measures and find three key results: liquidity timing leads to tangible economic gains; a risk-averse investor will pay a high performance fee to switch from a dynamic portfolio strategy based on various liquidity measures to one that conditions on the Zeros measure (Lesmond et al., 1999); the Zeros measure outperforms other liquidity measures because of its robustness in extreme market conditions. These findings are stable over time and robust to controlling for existing market return predictors or considering risk-adjusted returns.     

On the bi-dimensionality of liquidity

Variations in overall liquidity can be measured by simultaneous changes in both immediacy costs and depth. Liquidity changes, however, are ambiguous whenever both liquidity dimensions do not reinforce each other. In this paper, ambiguity is characterized using an instantaneous time-varying elasticity concept. Several bi-dimensional liquidity measures that cope with the ambiguity problem are constructed. First, it is shown that bi-dimensional measures are superior since commonalities in overall liquidity cannot be fully explained by the common factors in one-dimensional proxies of liquidity. Second, it is shown that an infinitesimal variation in either market volatility or trading activity augments the probability of observing an unambiguous liquidity adjustment. Ambiguity strongly depends on the expected (deterministic) component of volatility.