Funding liquidity risk and the low-volatility anomaly: Evidence from the Taiwan stock market

Abstract

We investigate whether the funding liquidity risk to institutional investors influences the negative relation between expected returns and variance (the ‘‘Low-volatility anomaly’’). With the Taiwan stock market as a setting, we implement a multivariate Markov switching model and use the funding liquidity risk to model the time-varying transition probabilities of the regime-switching process to capture changes in the funding liquidity risk regime. Our evidence documents that the low-volatility anomaly is most pronounced when there is high funding liquidity risk. When there is low funding liquidity risk, however, the low-volatility anomaly has a significant reversal. These results imply that the increased funding liquidity risk due to financial shock transmitted from parent banks is associated with higher selling pressure on institutional investors’ high-volatility stocks, leading to the low-volatility anomaly.