Liquidity and Commonality in Emerging Markets

Abstract

Emerging markets share many distinct features that separate them from more developed markets, including a low level of liquidity. In this study, I investigate the extent to which the liquidity of emerging market stocks co-moves with that of other stocks in the same market. I document a significantly higher commonality in liquidity in emerging markets than in developed markets. My empirical results show that in emerging markets individual stock liquidity is more affected by fluctuations in market prices than by fluctuations in individual stock prices, suggesting that higher commonality in liquidity in emerging markets could be caused by higher co-variation in stock volatility and inventory risk. Consistent with this conjecture, commonality in liquidity is found to be positively related to co-movement in volatility, and with level of development of the financial markets. These findings reinforce the idea that liquidity commonality is related to market-wide factor. I also document that liquidity co-movement across emerging markets has a strong geographic component and is related to correlation in market-wide volatility. The initial results do not support the presence of a global liquidity factor, and suggest that liquidity risk can be diversified by constructing global portfolios.