Firm size,ownership structure,and systematic liquidity risk: The case of an emerging market

Previous studies support the hypothesis that institutional ownership leads to an enhanced systematic liquidity risk by increasing the commonality in liquidity. By using a proprietary database of all incoming orders and ownership structure in an emerging stock market, we show that institutional ownership leads to an increase in commonality in liquidity for mid- to-large cap firms; however, only individual ownership can lead to such an increase for small cap firms, revealing a new source of systematic liquidity risk for a specific group of firms. We also reveal that commonality decreases with the increasing number of investors (for both individual and institutional) at any firm size level; suggesting that as the investor base gets larger, views of market participants become more heterogeneous, which provides an alternative way to decrease the systematic liquidity risk.     

Commonality in returns,order flows,and liquidity in the Greek stock market

Using a unique high-frequency data-set on a comprehensive sample of Greek blue-chip stocks, spanning from September 2003 through March 2006, this note assesses the extent and role of commonality in returns, order flows (OFs), and liquidity. It also formally models aggregate equity returns in terms of aggregate equity OF, in an effort to clarify OF's importance in explaining returns for the Athens Exchange market. Almost a quarter of the daily returns in the FTSE/ATHEX20 index is explained by aggregate own OF. In a second step, using principal components and canonical correlation analyses, we document substantial common movements in returns, OFs, and liquidity, both on a market-wide basis and on an individual security basis. These results emphasize that asset pricing and liquidity cannot be analyzed in isolation from each other.     

In Defence of Capitalisation Weights: Evidence from the FTSE 100 and S&P 500 Indices

A simple method for decomposing the variance covariance matrix of portfolio returns at the level of individual stocks is applied to the FTSE 100 Index. During extreme negative shocks, the largest index constituents exhibit lower than average covariance, thereby reducing the volatility of the capitalisation‐weighted index. The risk‐adjusted returns of the capitalisation‐weighted FTSE 100 Index exceed those of an equally‐weighted version of the same index and the outperformance is robust to the method of risk adjustment applied. The equally‐weighted index also exhibits greater systematic (market) risk than the capitalisation‐weighted version.     

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.     

Information costs and liquidity effects from changes in the FTSE 100 list

Abstract

In this paper we examine the stock price effect of changes in the composition of the FTSE 100 over the time period of 1984–2001. Like the S&P 500 listing studies, we find that the price and trading volume of newly listed firms increases. The evidence is consistent with the information cost/liquidity explanation. This is because investors hold stocks with more available information, implying that they have lower trading costs. This explains the increase in the stock price and trading volume of newly listed stocks to the FTSE 100 List. We find the reverse effect for the deletions from the FTSE 100.     

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.     

City goes dark: Dark trading and adverse selection in aggregate markets

We investigate the impact of dark trading on adverse selection in an aggregate market for trading UK stocks. Dark trading is linked to lower adverse selection risk and improved informational efficiency and liquidity in the aggregate market, even as liquidity declines in the lit market with dark trading. However, there is a trading value-based threshold when dark trading starts to induce adverse selection. We estimate that this threshold varies from around 9% for the most liquid stocks to 25% for the least liquid stocks. The overall average threshold for the 288 FTSE 350 stocks in our sample is 14%.     

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.     

Systematic liquidity risk and stock price reaction to shocks

This study examines the relationship between systematic liquidity risk and stock price reaction to large 1‐day price changes (or shocks). We base our analysis on a yearly updated constituents list of the FTSE All share index. Our overall results are consistent with the price continuation hypothesis, which suggests that positive (negative) shocks will be followed by positive (negative) abnormal returns. However, further analysis indicates that stocks with low systematic liquidity risk react efficiently to both positive and negative shocks, whereas stocks with high systematic liquidity risk underreact to both positive and negative shocks. Our results are valid irrespective of various robustness tests such as size of the shock, size of the firm, month‐of‐the‐year and day‐of‐the‐week effects. We conclude that trading on price patterns following shocks may not be profitable, as it involves taking substantial liquidity exposure.     

Stock Market Liquidity and the Business Cycle

In the recent financial crisis we saw liquidity in the stock market drying up as a precursor to the crisis in the real economy. We show that such effects are not new; in fact, we find a strong relation between stock market liquidity and the business cycle. We also show that investors' portfolio compositions change with the business cycle and that investor participation is related to market liquidity. This suggests that systematic liquidity variation is related to a “flight to quality” during economic downturns. Overall, our results provide a new explanation for the observed commonality in liquidity.     

Commonality in liquidity and multilateral trading facilities

We use the introduction of two multilateral trading facilities (MTFs) to examine the impact of market fragmentation on commonality in liquidity. We find that the introduction of MTFs following the Markets in Financial Instruments Directive increases the comovement of stocks’ liquidity with MTF liquidity, while the comovement with the home market liquidity generally decreases. We also find that the higher the MTF trading volume or the number of MTFs trading a stock, the stronger the effect. Further, we find that the commonality in liquidity remains unchanged for a matched control sample of stocks that do not trade on MTFs.     

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.     

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.     

What Style Liquidity Timing Skills Do Mutual Fund Managers Possess?

Recent studies claim that mutual fund managers demonstrate strong MARKET liquidity timing skills. We extend their liquidity timing tests to the four‐factor case and investigate liquidity timing skills with respect to the MARKET, SIZE, VALUE and MOMENTUM factors. Contrary to these claims, we find no evidence that fund managers adjust market exposure in anticipation of market liquidity changes. We find rather strong evidence that fund managers successfully overweight small stocks as market liquidity increases. Our study also demonstrates that it is easy to misidentify SIZE liquidity timing as MARKET liquidity timing in models that focus only on MARKET liquidity timing.     

Commonality in Liquidity: Evidence from an Order-Driven Market Structure

Events such as the 1997 East Asian financial crisis indicate that individual firm liquidity is strongly influenced by marketwide factors. Previous market microstructure research, however, focuses almost exclusively on the firm‐specific attributes of liquidity. Our study follows the recent shift in emphasis toward commonality by examining systematic liquidity in an order‐driven market structure. Using data from the Stock Exchange of Hong Kong, we show that commonality in liquidity includes both market and industry components, and is pervasive across size‐sorted portfolios. We also find a significant market and industry component in individual firms' order flow. In contrast to quote‐driven results, we do not find a positive relation between firm size and sensitivity to changes in marketwide bid‐ask spreads.     

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.     

The impact of aggressive orders in an order-driven market: a simulation approach

This article investigates resiliency in an order-driven market. On basis of a vector autoregressive model capturing various dimensions of liquidity and their interactions, I simulate the effect of a large liquidity shock, measured by a very aggressive market order. I show that, despite the absence of market makers, the market is resilient. All dimensions of liquidity (spread, depth at the best prices and order book imbalances) revert to their steady-state values within 15 orders after the shock. For prices, a long run effect is found. Furthermore, different dimensions of liquidity interact. Immediately after a liquidity shock, the spread becomes wider than in the steady state, implying that one dimension of liquidity deteriorates, while at the same time, depth at the best prices increases, meaning an improvement of another liquidity dimension. In subsequent periods, the spread reverts back to the steady-state level but also depth decreases. Also, I find evidence for asymmetries in the impact of shocks on the ask and bid side. Shocks on the ask side have a stronger impact than shocks on the bid side. Finally, resiliency is higher for less-frequently traded stocks and stocks with a larger relative tick size.     

How is illiquidity priced in the Chinese stock market?

This study investigates the liquidity premium in the Chinese stock market. We found that the expected stock returns increase monotonically with the quintile sort on characteristic liquidity with descending patterns. The characteristic liquidity premium ranges from 0.82% to 1.28% per month, which is much higher than that of their US counterparts. Moreover, our multivariate decomposition approach highlights that characteristic illiquidity premiums can be explained mainly by size, idiosyncratic volatility and momentum. The net systematic liquidity premium reaches 0.84% per month, driven mainly by commonality beta. The finding shows that a liquidity-based strategy forecasts cross-section and time-series expected returns.     

The divergence of liquidity commonality in the cross-section of stocks

This paper demonstrates that the cross-sectional variation of liquidity commonality has increased over the period 1963–2005. The divergence of systematic liquidity can be explained by patterns in institutional ownership over the sample period. We document that our findings are associated with similar patterns in systematic risk. Our analysis also indicates that the ability to diversify systematic risk and aggregate liquidity shocks by holding large-cap stocks has declined. The evidence suggests that the fragility of the US equity market to unanticipated events has increased over the past few decades.