Volatility and Liquidity

Abstract

Liquidity affects various capital market outcomes such as expected returns and capital structure. Prior research has shown that an important determinant of liquidity is volatility, where higher stock return volatility is associated with higher illiquidity. Using recent developments in the literature, we revisit this relation and decompose total volatility into its jump and diffusive components. Our investigation is motivated by the fact that variation in the structure of volatility is driven by variation in economic factors across firms and by the fact that the two volatility components are predicted to have differential effects on liquidity. We find that the positive relation between total volatility and illiquidity is exclusively driven by the jump component, and is independent of any information asymmetry effects. In contrast, we find a negative relation between diffusive volatility and illiquidity. We show that this negative relation is driven by the positive association between diffusive volatility and trading activity. Finally, we show that these findings translate to differential effects for jump and diffusive volatility components on liquidity risk and premium. Our findings have implications for the understanding of asset prices, corporate finance decisions and policy-makers.