Abstract
Whereas conventional wisdom argues that markets shut down during crises, with sellers struggling to find buyers, we find that markets continue to operate during financial turmoil, even in narrow and volatile emerging economies. Simple event studies indicate that both trading volume and trading costs increase in crisis times. Prices change more with each dollar transacted (pushing the Amihud illiquidity measure up) and bid-ask spreads widen. More generally, econometric estimates show that large price downturns, typical of crises, are associated with higher trading activity and increased trading costs, with trading activity declining only later as crises progress. Thus, although trading activity tends to be negatively related to trading costs during tranquil times (and across securities), this relation appears to break down during crises. These results are consistent with the analytical literature on portfolio rebalancing by heterogeneous agents in times of crises.
Highlights
As conventional wisdom has it, markets shut down during financial crises, as sellers struggle to find their buyers.1 an empirical assessment of what really goes on with secondary market liquidity in periods of financial distress is far from trivial, as a quick survey of the related literature illustrates
Whereas the relation between liquidity and market returns in the United States has been studied extensively in both directions, the results differ according to the measures of liquidity in use
Chordia et al (2005) find that crises and returns raise trading costs, while Hameed et al (2006) report that bid-ask spreads fall after significant negative market returns when controlling for demand effects, supporting the collateral-based view
Summary
As conventional wisdom has it, markets shut down during financial crises, as sellers struggle to find their buyers.1 an empirical assessment of what really goes on with secondary market liquidity in periods of financial distress is far from trivial, as a quick survey of the related literature illustrates. JEL Classification Codes: F30; G10; G12; G14 Keywords: liquidity crisis; stock markets; trading activity; trading volume; trading cost; Amihud illiquidity ratio; bid-ask spreads
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