Alternative Liquidity Measures Research Articles

Liquidity Commonalities in the Credit Default Swap Market

This study presents robust empirical evidence suggesting the existence of significant liquidity commonalities in the corporate Credit Default Swap (CDS) market. Using daily data for 438 firms from 25 countries in the period 2005-2012 we find that these commonalities vary over time, being stronger in periods in which the global, counterparty, and funding liquidity risks increase. However, commonalities do not depend on firm’s characteristics. The level of the liquidity commonalities differs across economic areas being on average stronger in the European Monetary Union. The effect of market liquidity is stronger than the effect of industry specific liquidity in most industries excluding the banking sector. We document the existence of asymmetries in commonalities around financial distress episodes such that the effect of market liquidity is stronger when the CDS market price increases. The results are not driven by the CDS data imputation method or by the liquidity of firms with high credit risk and are robust to alternative liquidity measures.

Stock market liquidity and firm value

This paper investigates the relation between stock liquidity and firm performance. The study shows that firms with liquid stocks have better performance as measured by the firm market-to-book ratio. This result is robust to the inclusion of industry or firm fixed effects, a control for idiosyncratic risk, a control for endogenous liquidity using two-stage least squares, and the use of alternative measures of liquidity. To identify the causal effect of liquidity on firm performance, we study an exogenous shock to liquidity—the decimalization of stock trading—and show that the increase in liquidity around decimalization improves firm performance. The causes of liquidity's beneficial effect are investigated: Liquidity increases the information content of market prices and of performance-sensitive managerial compensation. Finally, momentum trading, analyst coverage, investor overreaction, and the effect of liquidity on discount rates or expected returns do not appear to drive the results.

Turnover: Liquidity or Uncertainty?

I show that turnover is unrelated to several alternative measures of liquidity and liquidity risk and that liquidity risk factors cannot explain why higher turnover predicts lower future returns. I find that the aggregate volatility risk factor explains why higher turnover predicts lower future returns. I also find that the negative relation between turnover and future returns is stronger for firms with high market-to-book or bad credit rating and these regularities are also explained by the aggregate volatility risk factor.

Pricing the Commonality Across Alternative Measures of Liquidity

We estimate latent factor models of liquidity, aggregated across various liquidity measures. Shocks to assets' liquidity have a common component across measures which accounts for most of the explained variation in individual liquidity measures. We find that across-measure systematic liquidity is a priced factor while within-measure systematic liquidity does not exhibit additional pricing information. Controlling for across-measure systematic liquidity risk, there is some evidence that liquidity, as a characteristic of assets, is priced in the cross-section. Our results are robust to the inclusion of other equity characteristics and risk factors, such as market capitalization, book-to-market, and momentum.

Pricing the commonality across alternative measures of liquidity

We estimate latent factor models of liquidity, aggregated across various liquidity measures. Shocks to assets’ liquidity have a common component across measures which accounts for most of the explained variation in individual liquidity measures. We find that across-measure systematic liquidity is a priced factor while within-measure systematic liquidity does not exhibit additional pricing information. Controlling for across-measure systematic liquidity risk, there is some evidence that liquidity, as a characteristic of assets, is priced in the cross-section. Our results are robust to the inclusion of other equity characteristics and risk factors, such as market capitalization, book-to-market, and momentum.

The Relation between Liquidity Risk and Default Risk in Equity Returns

This paper demonstrates the relative importance of default and liquidity risks in equity returns. While previous studies have shown that both default and liquidity risks affect equity returns, none, to our knowledge, has examined their interrelation and relative importance for equity returns. We consider three alternative liquidity measures: the Pastor-Stambaugh measure, the turnover measure, and the illiquidity ratio measure. The default measure of choice is the one based on Merton's (1974) contingent claims approach. The alternative liquidity measures are very different from each other, but they are all related to our default measure. While we know from past research that low liquidity stocks earn higher returns than high liquidity stocks, we demonstrate here that this is the case only when these stocks also have high default risk, and in no other case. In contrast, high default risk stocks always earn higher returns than low default risk stocks, independently of their liquidity level. Vector autoregressive tests reveal the existence of a two-way causal relation between default risk and stock market returns, which is not present in the case of liquidity. Liquidity risk does not affect the future path of stock market returns. The robustness of these relations remains unaltered when we take into account the correlation of the default and liquidity measures with aggregate stock market volatility. Consistent with previous evidence, the inclusion of default and liquidity variables in popular asset pricing specifications improves a model's performance. However, the improvement is much larger when the included variable is default, rather than liquidity. In the presence of the default variable, the inclusion of a liquidity proxy in an asset pricing specification results in only a marginal improvement of the model's performance. The opposite is not true.

Commonality Across Alternative Measures of Liquidity

Commonality Across Alternative Measures of Liquidity