An Empirical Analysis of Stock and Bond Market Liquidity

Abstract

This article explores cross-market liquidity dynamics by estimating a vector autoregressive model for liquidity (bid-ask spread and depth, returns, volatility, and order flow in the stock and Treasury bond markets). Innovations to stock and bond market liquidity and volatility are significantly correlated, implying that common factors drive liquidity and volatility in these markets. Volatility shocks are informative in predicting shifts in liquidity. During crisis periods, monetary expansions are associated with increased liquidity. Moreover, money flows to government bond funds forecast bond market liquidity. The results establish a link between macro liquidity, or money flows, and micro or transactions liquidity. A number of important theorems in finance rely on the ability of investors to trade any amount of a security without affecting the price. However, there exist several frictions,1 such as trading costs, short sale restrictions, and circuit breakers, that impact price formation. The influence of market imperfections on security pricing has long been recognized. Liquidity, in particular, has attracted a lot of attention from traders, regulators,