Liquidity-Based Cross-Sectional Variation in Stocks' Responses to Market Volatility Shocks

Abstract

We study liquidity-based cross-sectional variation in how stock returns and turnover respond to market volatility shocks over the 1986-2012 period, as measured by the CBOE's VIX. Controlling for individual equity betas and return volatility, we find that more liquid stocks exhibit: (1) more negative average returns and relatively larger turnover, contemporaneous with the VIX-increase days, (2) a return reversal following the extreme VIX-increase days with relatively large positive average returns over the next week and month, and (3) a more negative return autocorrelation following the VIX-increase days. For large VIX-decrease days, the more liquid stocks exhibit more positive average returns and relatively higher turnover, but no reversals in subsequent returns. Since times with large stock-volatility shocks are likely to be times with relatively less liquidity and more cross asset-class rebalancing, our findings seem intuitive because the more liquid stocks would: (1) take the brunt of cross asset-class rebalancing since their size dominates the market's capitalization; and (2) be relatively cheaper to trade during illiquid times. Our findings bear on predictions from recent theoretical models.