A comparison among various dimensions of illiquidity effect: A case study of Finland

We study different dimensions of the illiquidity effect on asset returns in the Finnish market. The market illiquidity is measured as unexpected rises and falls in average monthly zero returns across all stocks. We find that for the returns on the specific class of assets, a flight to the liquidity effect is the most important systematic risk among all dimensions of the illiquidity effect. In other words, higher returns for illiquid assets in good times compensate for a pronounced drop in those returns in bad times and vice versa. Furthermore, only one illiquidity-related factor has a similar pricing capacity as Fama and French's (1993) three-factor model and Carhart's (1997) four-factor model in the context of this study.     

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.     

Illiquidity,return and risk in G7 stock markets: Interdependencies and spillovers

Trading activity in G7 stock markets reflects not only the macroeconomic and financial impact of these G7 economies in international economic growth, but also their financial interdependence. While this nexus of major stock markets has been explored in terms of volatility and return spillovers, there has been no combined analysis of return, volatility and illiquidity spillovers. We study illiquidity spillovers because they are transmissions of trading activity and, thereof, transmissions of information and market sentiment. We find that the dynamics of international stock markets are characterized by persistent illiquidity and also that illiquidity shocks are significantly correlated across markets. Furthermore, we discover Granger causal associations between risk, return and illiquidity across G7 stock market and also within each stock market. Our findings bear significance for the regulation of international financial markets and also for international portfolio diversification.     

Liquidity and stock returns in Japan: New evidence

The liquidity/stock returns linkage was studied using data from the First Section, the Second Section, and the Mothers Section of the Tokyo Stock Exchange (TSE). In our overall tests, we found a significantly negative (positive) relationship between liquidity (illiquidity) proxies and returns. Upon exploring this further for the impact of business cycles, we found that while the expansionary phases largely confirm the overall finding, contractionary phases do not. When we controlled for liquidity variability in the cross-sectional regressions, the role of the liquidity level showed strong significance across business cycles, different subperiods and all Sections of the TSE. With regard to liquidity variability, we observed a strongly significant and negative association with stock returns.     

A model of liquidity hoarding and term premia in inter-bank markets

Financial crises are associated with reduced volumes and extreme levels of rates for term inter-bank loans, reflected in one-month and three-month LIBOR. We explain such stress by modeling leveraged banks' precautionary demand for liquidity. Asset shocks impair a bank's ability to roll over debt because of agency problems associated with high leverage. In turn, banks hoard liquidity and decrease term lending as their rollover risk increases over the term of the loan. High levels of short-term leverage and illiquidity of assets lead to low volumes and high rates for term borrowing. In extremis, inter-bank markets can completely freeze.     

Hedge fund liquidity and performance: Evidence from the financial crisis

We investigate how share restrictions affect hedge fund performance in crisis and non-crisis periods. Consistent with prior research, we find that in the pre-crisis period more illiquid funds generate a share illiquidity premium compensating investors for limited liquidity. In the crisis period, this share illiquidity premium turns into an illiquidity discount. Hedge funds with more stringent share restrictions invest more heavily in illiquid assets. While share restrictions enable funds to manage illiquid assets effectively in the pre-crisis period, they seem insufficient to ensure effective management of illiquid portfolios in the crisis. In a crisis period, funds holding illiquid portfolios experience lower returns and alphas, also when share restrictions are controlled for. Funds with an asset–liability mismatch perform particularly poorly and experience the strongest outflows. Share restrictions are also a proxy for incentives as investors cannot immediately withdraw their money after poor performance. We show that higher incentive fees can offset the share illiquidity discount in the crisis period.     

Static and dynamic liquidity spillovers in the Eurozone: The role of financial contagion and the Covid-19 pandemic

This paper investigates static and dynamic liquidity spillovers for a pool of ten Eurozone countries for the period 2000–2021. We estimate a generalised vector autoregressive (VAR) model based on Diebold and Yilmaz (2009, 2012). We find evidence for static and dynamic transmission of shocks through the liquidity channel. We propose a static measure of liquidity spillovers which captures total and pairwise average spillovers across Eurozone countries. Our measure shows strong evidence of interconnection within the Eurozone through the liquidity channel. We investigate the dynamic intensity and direction of liquidity spillovers, finding significant evidence of contagion during crisis periods. Our results indicate that most of the shocks during periods of financial uncertainty arise from leading economies within the Euro area.     

Liquidity and valuation in an uncertain world

During the 2007–2009 financial crisis there was little or no trading in a variety of financial assets, even though bid and ask prices existed for many of these assets. We develop a model in which this illiquidity arises from uncertainty, and we argue that this new form of illiquidity makes bid and ask prices unsuitable as metrics for establishing “fair value” for these assets. We show how the extreme uncertainty that traders face can be characterized by incomplete preferences over portfolios, and we use Bewley's (2002) model of decision making under uncertainty to derive equilibrium quotes and the nonexistence of trading at these quotes. We then suggest alternatives for valuing assets in illiquid markets.     

Performance of Thinly Traded Assets: A Case in Real Estate

Thinly traded private assets do not fit into the traditional finance paradigm of a liquid and well‐functioning market where trading is continuous and instantaneous. Since private assets cannot be bought and sold easily, they bear liquidity risk. Classical finance theories cannot properly gauge the performance of illiquid private assets because they implicitly assume such illiquidity is trivial. This paper proposes an alternative performance metric for the illiquid private asset, which explicitly captures liquidity risk in a formal analysis. Applying the new performance metric, we are able to explain the decades‐old “real estate risk premium puzzle.”     

Episodic Liquidity Crises: Cooperative and Predatory Trading

We describe how episodic illiquidity arises from a breakdown in cooperation between market participants. We first solve a one‐period trading game in continuous‐time, using an asset pricing equation that accounts for the price impact of trading. Then, in a multi‐period framework, we describe an equilibrium in which traders cooperate most of the time through repeated interaction, providing apparent liquidity to one another. Cooperation breaks down when the stakes are high, leading to predatory trading and episodic illiquidity. Equilibrium strategies that involve cooperation across markets lead to less frequent episodic illiquidity, but cause contagion when cooperation breaks down.     

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.     

Risk spillovers in international equity portfolios

We define risk spillover as the dependence of a given asset variance on the past covariances and variances of other assets. Building on this idea, we propose the use of a highly flexible and tractable model to forecast the volatility of an international equity portfolio. According to the risk management strategy proposed, portfolio risk is seen as a specific combination of daily realized variances and covariances extracted from a high frequency dataset, which includes equities and currencies. In this framework, we focus on the risk spillovers across equities within the same sector (sector spillover), and from currencies to international equities (currency spillover). We compare these specific risk spillovers to a more general framework (full spillover) whereby we allow for lagged dependence across all variances and covariances. The forecasting analysis shows that considering only sector- and currency-risk spillovers, rather than full spillovers, improves performance, both in economic and statistical terms.     

The Impact of Short-Sales Constraints on Liquidity and the Liquidity–Return Relations

Baker and Stein's (2004) model predicts that individual stock liquidity, commonality in liquidity across stocks, the contemporaneous correlation between stock returns and liquidity, and the degree of high liquidity associated with low subsequent stock returns decrease in the absence of short-sales constraints relative to in the presence. To test these theoretical predictions, we examine both the component stocks of the Taiwan 50 index and other nonindex stocks for the sample period before and after the removal of short-sales constraints on the former and use trading turnover and Amihud's (2002) illiquidity ratio as the measure of liquidity to proxy for investor sentiment. Overall, our empirical results are consistent with these theoretical predictions and therefore provide evidence in support of Baker and Stein's (2004) model.     

Modeling Sovereign Yield Spreads: A Case Study of Russian Debt

We construct a model for pricing sovereign debt that accounts for the risks of both default and restructuring, and allows for compensation for illiquidity. Using a new and relatively efficient method, we estimate the model using Russian dollar-denominated bonds. We consider the determinants of the Russian yield spread, the yield differential across different Russian bonds, and the implications for market integration, relative liquidity, relative expected recovery rates, and implied expectations of different default scenarios.     

Bank regulatory capital and liquidity: Evidence from US and European publicly traded banks

The theory of financial intermediation highlights various channels through which capital and liquidity are interrelated. Using a simultaneous equations framework, we investigate the relationship between bank regulatory capital and bank liquidity measured from on-balance sheet positions for European and US publicly traded commercial banks. Previous research studying the determinants of bank capital buffer has neglected the role of liquidity. On the whole, we find that banks decrease their regulatory capital ratios when they face higher illiquidity as defined in the Basel III accords or when they create more liquidity as measured by Berger and Bouwman (2009). However, considering other measures of illiquidity that focus more closely on core deposits in the United States, our results show that small banks strengthen their solvency standards when they are exposed to higher illiquidity. Our empirical investigation supports the need to implement minimum liquidity ratios concomitant to capital ratios, as stressed by the Basel Committee; however, our findings also shed light on the need to further clarify how to define and measure illiquidity and also on how to regulate large banking institutions, which behave differently than smaller ones.     

Self‐Fulfilling Liquidity Dry‐Ups

I analyze a model in which holding cash imposes a negative externality: it worsens future adverse selection in markets for long‐term assets, which impairs their role for liquidity provision. Adverse selection worsens when potential sellers of long‐term assets hold more cash because then fewer sales reflect cash needs, and proportionally more sales reflect private information. Moreover, future market illiquidity makes current cash holding more appealing. This feedback effect may result in hoarding behavior and a market breakdown, which I interpret as a self‐fulfilling liquidity dry‐up. This mechanism suggests that imposing liquidity requirements on financial institutions may backfire.     

Liquidity and Credit Risk

We develop a structural bond valuation model to simultaneously capture liquidity and credit risk. Our model implies that renegotiation in financial distress is influenced by the illiquidity of the market for distressed debt. As default becomes more likely, the components of bond yield spreads attributable to illiquidity increase. When we consider finite maturity debt, we find decreasing and convex term structures of liquidity spreads. Using bond price data spanning 15 years, we find evidence of a positive correlation between the illiquidity and default components of yield spreads as well as support for downward‐sloping term structures of liquidity spreads.     

The liquidity cost implications arising from the attraction of regional primary listings: Evidence from West Africa

This study reviews the liquidity costs for firms in outlying regions in primary listing on a centralized stock exchange. Using a unique hand-collected sample comprising all listed firms from across West Africa we find evidence that firms from outlying regions do have higher illiquidity costs although these can be mitigated from improvements in transparency that are associated with increasing familiarity amongst investment community of central exchange. This evidence has implications regarding the integration of stock exchanges in developing regions where this is likely to result in a greater concentration of liquidity mitigating intended optimal redistribution of capital and resources.     

Liquidity and CDS premiums on European companies around the Subprime crisis

This paper sheds new light on the liquidity dynamics of the credit default swaps (CDS) market in Europe around the Subprime crisis. Based on an original dataset of 94 European companies from 2005 to 2009, we use a panel regression analysis to study the relationship between CDS premiums and liquidity. We measure the level of liquidity, look at liquidity risk, and study the liquidity spillovers from the bond and equity markets to the CDS market. We show that the effect of liquidity on CDS premiums is dominated by the influence of worsening credit conditions and deteriorating investors?? expectations about default risk. Controlling for credit risk, we also find that liquidity risk is priced in the European CDS market and that liquidity spillovers from the bond market matter in determining CDS premiums.     

Market-wide illiquidity and the distribution of non-parametric stochastic discount factors

Employing out-of-sample non-parametric estimation techniques, we show that market-wide liquidity risk matters for asset pricing independently of the specific functional form of the stochastic discount factor (SDF) and, therefore, of the asset pricing model specification. Market-wide illiquidity significantly affects the distribution of the SDF. Specifically, it boosts up the volatility of the SDF, causing minor effects on higher moments of its distribution. This finding is robust to the use of different sets of test assets in the estimation of the SDF, including equity and corporate bond portfolios, and the use of a high-dimensional data estimation procedure.