The Changing State of the Market: Common Factors and Impulse Responses for Cointegrated Spreads and Depths

Abstract

We investigate the impulse response path through which an information or liquidity shock reveals itself first in depths and then in subsequent adjustments of the spread. Our three-equation error correction model investigates the equilibrium properties of spread and depth adjustment. In particular, we estimate orthogonalized impulse responses and Gonzalo-Granger common factor weights to discern whether spreads or depths are first to permanently impound the common stochastic trends in liquidity and information fundamentals. Using three years of NYSE quote data on the DJIA stocks, we show that depths decline in response to positive shocks to the spread but that this effect is not permanent. In contrast, spreads widen initially in response to positive depth shocks as orders walk the but subsequent net tightening occurs within less than two minutes and proves to be a permanent effect. As order flow imbalance appears, the resulting quote changes quickly elicit undisplayed (off-market) liquidity. We conclude that the NYSE book refreshes very quickly.