Illiquidity Costs Research Articles

Cost of Illiquidity: Marketability and Liquidity Discounts in a Margrabe Exchange Option Framework

ABSTRACT Market declines of 2008–2009 and 2022–2023 brought renewed attention to the issue of illiquidity and the attendant costs faced by the stockholders. Margrabe exchange option-based models have been employed widely for estimating the cost of illiquidity (price risk). These models estimate the exchange ratio for two assets where the future price of both assets is unknown. Treating one of the assets as a numeraire, or currency in which the other asset is priced, simplifies the model and makes it easily tractable. Some authors have ignored this distinction, leading to inflated estimates for illiquidity discounts (sometimes exceeding 100 percent, a logical fallacy). In this paper, I present a uniform framework (the Margrabe exchange option) comparing the estimated cost of illiquidity under different information asymmetry assumptions. Empirical results presented are consistent with the theoretical predictions in that the expected rank order for estimated costs under different formulations is preserved. JEL Classifications: C52; D47; D82; G13; K22.

Exploring illiquidity risk pre and during the COVID-19 pandemic era: Evidence from international financial markets

Research aims: Illiquidity risk is one of the complex issues that institutional investors and market participants continually face over time. It is because the constructs of illiquidity risk are sometimes complicated, robust, and not so evident in secondary markets. Hence, this study aims to empirically explore illiquidity risk before and during the COVID-19 pandemic to understand how much investors were expected to lose if they invested in stock markets during these periods.Design/Methodology/Approach: This study used a GARCH model and the Amihud illiquidity ratio to achieve its objective. Trading volumes and price returns for the JSE, CAC 40, DAX, Nasdaq, BIST 100, and SSE were from June 30, 2017, to June 30, 2019, and January 1, 2020, to December 31, 2021.Research findings: As expected, the findings revealed higher illiquidity risk during periods of financial distress, such as the COVID-19 pandemic. During the financial crisis, investors could lose up to $22268.44 a day in less developed markets, such as the JSE, while the average loss in developed markets ranged between $0.22 to $11.53 in the Nasdaq and DAX, respectively. On average, a much lower figure was observed before the financial crisis. The BIST100, CAC 40, DAX, and Nasdaq are excellent options for those seeking lower-risk premiums.Theoretical and Practitioner/Policy implication: Policies such as adequate market microstructure and greater transparency in trading are strongly recommended for less developed markets, especially during periods of financial distress. Also, the findings of this study provide valuable insight into short-term traders and market participants attracted to liquid markets, where they can easily enter and exit their positions with minimal transaction costs. To the author's knowledge, this paper is the first to model illiquidity risk in stock markets.Research limitation/Implication: It is possible that the current study did not accurately capture the cost of illiquidity in the sampled financial markets and cannot be applied to other financial markets.

Deviations from covered interest parity in the emerging markets after the global financial crisis

In this paper, we focus on six emerging market economies to study the magnitude of systemic and persistent deviations from covered interest parity (CIP) using daily data between January 2010 and July 2018. We show the significant role of local factors, particularly credit and liquidity risk, in explaining sustained CIP deviations in these markets. Our findings suggest that the impact of credit risk on CIP deviations in emerging market economies may take two forms. In low-carry currencies, the well-known mechanism for credit risk operates so that the increase in credit risk exacerbates CIP deviations. Conversely, in high-carry currencies, the high usage of foreign exchange swaps makes swap rates react more than domestic rates, which causes CIP to decrease. We also present evidence that cost of illiquidity is an important driver to explain CIP deviations. We demonstrate that increased liquidity in emerging market currencies is not as large to prevent CIP deviations.

The Shadow Costs of Illiquidity

AbstractWe solve a flexible model that captures transactions costs and infrequencies of trading opportunities for illiquid assets to better understand the shadow costs of illiquidity for different origins of asset illiquidity and heterogeneous investor types. We show that illiquidity that results in suboptimal asset allocation carries low shadow costs, whereas these costs are high when illiquidity restricts consumption. As a result, the shadow costs are high for short-term investors, investors who face substantial liquidity shocks, and investors who desire to allocate a large fraction of their wealth to illiquid assets.

Pakistan: a study of market's returns and anomalies

Purpose This paper aims to expand foreign investors' understanding of potential return enhancement and risk diversification advantages offered by equity market of Pakistan through comparing its performance to performances in other markets and investigating what matters for investing in Pakistan's market.Design/methodology/approachComparative analysis of Pakistan Stock Exchange is performed using data for 22 developed and 22 emerging markets over the period 1993–2019. Cross-sectional analysis is performed using data for 130 non-financial firms from Pakistan and Carhart (1997) and Fama and French (2015) models are applied. The role of liquidity with five-factor model is analyzed using turnover rate and Amihud (2002) illiquidity cost as liquidity measures.FindingsPakistan's equity offers substantial diversification benefits if added to developed market portfolios. However, observed large returns come together with inverted premia for most traditional factors indicating that investors may want to invest preferably in big stocks with low book-to-market and momentum. Finally, global investors can invest in high yielding stocks with low liquidity risk owing to positive connection between liquidity and returns.Practical implicationsThis study will provide investment model for foreign investors to enhance their portfolio returns. Policy makers in Pakistan must identify regulatory steps to facilitate foreign investments.Originality/valueTo the best of the authors' knowledge, this is the first study which identifies efficiency gains offered by Pakistan's equity for global investors.

Aggregate liquidity premium and cross-sectional returns: Evidence from China

The Chinese stock market incurs huge illiquidity costs. Liquidity has different aspects but literature rarely measures it from an aggregate perspective. To capture liquidity along various dimensions and more consistently, we propose an aggregate liquidity premium with a partial least squares approach by aggregating information on 12 liquidity-related firm characteristics in the Chinese stock market. The aggregate liquidity predictor generates significantly higher expected stock returns than individual characteristics, remains robust to different information aggregation methods, and reflects the multidimensional feature of liquidity. Behavioral mispricing theory helps explain the aggregate liquidity premium because illiquidity limits arbitrage to correct mispricing. As liquidity is important and traditional factor models limitedly explain it, we develop a new-factor model to capture the aggregate liquidity premium. The aggregate liquidity premium in China indicates that policymakers should improve market liquidity.

Navigating the factor zoo around the world: an institutional investor perspective

The literature on cross-sectional stock return predictability has documented over 450 factors. We take the perspective of an institutional investor and navigate this zoo of factors by focusing on the evidence relevant to the practicalities of factor-based investment strategies. Establishing a sound theoretical rationale is key to identifying “true” factors, and we emphasize the need to recognize data-mining concerns that may cast doubt on the relevance of many factors. From a practical investment perspective, much of the factor evidence documented by academics may be more apparent than real. The performance of many factors is dependent on the inclusion of small- and micro-cap stocks in academic studies, although such stocks would likely be excluded from the real investment universe due to illiquidity and transaction costs. Nevertheless, a parsimonious set of factors emerges in equities and other asset classes, including currencies, fixed income, and commodities. These factors can serve as meaningful ingredients to factor-based portfolio construction.

An international reserves variation threshold to increase loan funding

In this article we propose a methodology for the calculation of an international reserves variation threshold that defines the lending decisions of international creditors to developing countries. If the change in net international reserves of the borrowing variation is above that of the threshold, the creditors are willing to lend more. Otherwise, if that change is below the threshold, there will be capital flight. Such a threshold depends on the stocks of debt and international reserves, as well as on the perception of the default risk of the country to honour its debts. Using that threshold, we perform a counterfactual exercise to calculate the time series of international reserve levels that minimize the total cost of reserves holding, namely, the cost of possible illiquidity of the country plus the opportunity cost of holding international reserves. We illustrate the methodology by applying it to five Latin American countries: Argentina, Brazil, Chile, Mexico and Peru.

Assessing Gains from Primary Market Allocations in Corporate Bonds

Different market characteristics and investor behavior render the use of underpricing, widely used for equity IPOs, inadequate as a measure of gains from primary market allocations in corporate bonds. We propose a measure that reflects the illiquidity costs that investors save by avoiding acquiring the new bonds in secondary market and show that it can far exceed underpricing. We validate the measure by linking it to changes in secondary market liquidity arising from bond characteristics or induced by regulatory changes. We illustrate the value of the new measure by using it to document that “favoritism” in primary market allocations increases when secondary market liquidity is low.

The accounting of illiquidity and transaction costs during the delta-hedging

The article is devoted to the study of optimal time interval for re-hedging in the presence of illiquidity and transaction costs. A nonlinear Black – Scholes type equations are obtained for the case when the function of illiquidity costs is linear and quadratic. To determine the transaction costs, a risk-adjusted pricing methodology (RAPM) model is used. In order to demonstrate its practical application, the optimal time interval for the delta hedging is considered using an example of an optional combination «long butterfly».

Liquidity Risks and Asset Pricing: Evidence from Developed and Emerging Markets

The study examines the liquidity adjusted capital asset pricing model in developed and emerging markets. Amihud measure is used to compute market liquidity. Innovations in Amihud ratio are generated through the autoregressive process to avoid autocorrelation in illiquidity data series. Decile portfolios based on illiquidity cost are formulated for each stock market. Liquidity adjusted betas are calculated at the portfolio level and then stocks as test assets have been used in the regression stage. Panel regression with fixed effect has been employed on LCAPM specifications for explaining the excess stock returns of developed and emerging markets during a period July 2005- June 2017. The findings of the study support that individual and aggregate liquidity risk price in stock markets except for Pakistan. The results of the study suggest that investors institutional or individual should consider liquidity risks for assessing the worth of assets.

The Liquidity Premium Across Asset Classes

We solve a flexible model that captures transactions costs and infrequencies of trading opportunities for illiquid assets to better understand the shadow costs of illiquidity for different origins of asset illiquidity and heterogeneous investor types. We show that illiquidity that results in suboptimal asset allocation carries low shadow costs, whereas these costs are high when illiquidity restricts consumption. As a result, the shadow costs are high for short-term investors, investors who face substantial liquidity shocks, and investors who desire to allocate a large fraction of their wealth to illiquid assets.

Illiquidity contagion and pricing of commonality risk: Evidence from a dynamic conditional correlation model

This paper investigates the pricing of the commonality in liquidity risk in the U.S. stock market by using a more comprehensive measure of market illiquidity cost that can reflect the liquidity condition of broader asset markets, and by forming portfolios in a way that is consistent with the definition of the commonality risk. Estimating a conditional version of the Liquidity-Adjusted Capital Asset Pricing Model by the Dynamic Conditional Correlation approach, we find a commonality risk premium that is higher than those derived from alternative measures. The premium is time varying, with values being higher during periods of market turmoil.

Aggregate Liquidity Premium and Cross-sectional Returns: Evidence from China

The Chinese stock market incurs huge illiquidity costs. Liquidity has different aspects but literature rarely measures it from an aggregate perspective. To capture liquidity along various dimensions and more consistently, we propose an aggregate liquidity premium with a partial least squares approach by aggregating information on 12 liquidity-related firm characteristics in the Chinese stock market. The aggregate liquidity predictor generates significantly higher expected stock returns than individual characteristics, remains robust to different information aggregation methods, and reflects the multidimensional feature of liquidity. Behavioral mispricing theory helps explain the aggregate liquidity premium because illiquidity limits arbitrage to correct mispricing. As liquidity is important and traditional factor models limitedly explain it, we develop a new-factor model to capture the aggregate liquidity premium. The aggregate liquidity premium in China indicates that policymakers should improve market liquidity.

Does gender diversity on boards influence stock market liquidity? Empirical evidence from the French market

PurposeThe purpose of this paper is to examine the gender diversity on boards and its effect on stock market liquidity in French boardrooms.Design/methodology/approachUsing a sample of French firms between 2002 and 2012 listed on the Paris Stock Exchange (SBF120), the study uses ordinary least squares and three-stage least squares (3SLS) regressions to address endogeneity concerns on the board gender diversity.FindingsThe results show that stock market liquidity is positively and significantly associated with the presence of women directors. The authors find that investors’ decisions vary according to their positions in the board: women independent members decrease illiquidity costs, while the presence of female inside directors increases daily trading volume. In addition, the presence of female inside directors increases the firm’s ability to implement better strategies that cope with economic, social and environmental constraints which leads investors to positively react. Surprisingly, the presence of female independent directors reduces company involvement in sustainable development projects.Practical implicationsThe empirical findings contribute to the current debate on the benefits of gender diversity on corporate boards and the effectiveness of gender-quota laws. It shows that appointing insider female’ directors incite investors to trade more stocks while appointing independents ones reduces their trading costs.Social implicationsThis paper shows that the benefits of female directors appointing depend on their independence of management team.Originality/valueThis study addresses the endogeneity between stock market liquidity, corporate governance and gender diversity. It is the first study to distinguish between the effects of women inside and independent directors on investors’ trading decisions.

The Coasian Firm and Insider Trading, Revisited

I present an economic model of insider trading, building upon Haddock & Macey’s (1986) classic analysis of trading by the manager of a Coasian firm (i.e., a firm in which agency costs do not exist). Due to current shareholders’ status as expected sellers of shares, Coasian insider trading allows shareholders to expropriate outsiders via the managerial proxy, and any signaling value of insider trading is eliminated by shareholders’ biased incentives. Adverse selection results. If a system of credible disclosure exists, an insider trading ban results in more disclosure, more efficient prices, and lower illiquidity costs. While the case for insider trading in the Coasian firm may be weak, insider trading can provide positive social benefits where some form of agency cost exists. Insights from the Coasian model include that shareholder incentives may lead to undesirable capital markets activity, greater agency costs may result in preferable social outcomes, and deterrent penalties must take into account shareholder incentives.

Rebalancing-Diversification Return: The Opportunity Cost of Illiquid Investments

Institutional investors expect a return premium for illiquidity when an investment is private and cannot be sold easily in an established liquid market. For investors that have a very long investment horizon—and some might argue a permanent (or perpetual) investment portfolio—investments in private markets with any such level of expected return premium might seem to be dominant to a “liquid markets only” construct. However, how much should this premium be? The author hypothesizes that the illiquidity premium observed is directly related to the risk-equivalent liquid markets diversification-rebalancing returns forgone in pursuing illiquid investments. The author posits the excess return to illiquidity available to the long-term, non-liquidity constrained investor, is an investor-specific opportunity cost of illiquidity, and by logical extension, he proposes, an (efficient) market “opportunity cost to illiquidity” hypothesis. Finally, he examines the private equity industry benchmarking convention for performance evaluation—large-cap stocks + 300 bps—under this paradigm. <b>TOPICS:</b>Real assets/alternative investments/private equity, analysis of individual factors/risk premia, performance measurement

Optimal Deterrence When Shareholders Desire Fraud

This article presents an economic model of corporate fraud arising from shareholder incentives. First, the model shows that a firm’s current shareholders have a preference for higher reported values. Current shareholders are, in expectation, net sellers of the firm’s shares; a higher reported value of the firm increases current shareholder returns in expectation. Second, these preferences for inflationary misreporting translate into equilibrium misreporting behavior, which generates inefficiencies due to asymmetric information among secondary market traders. Informed traders undertake inefficient research costs, noise traders demand a discount in order to trade, and selling shareholders face deadweight illiquidity costs. Third, in general, some ex post penalty for misreporting can eliminate misreporting incentives and result in a unique truth-telling (i.e., separating) equilibrium. This improves social welfare. With joint-welfare maximization among the firm’s initial stakeholders and unlimited liability, it does not matter on whom the penalty is placed. Finally, the specific mechanism of firm-level (or “vicarious”) fines has desirable qualities from the perspective of administrative feasibility: the optimal fine is a simple function of observable market data. Compensation does not affect this formulation, yet compensation may be desirable in the event of incomplete deterrence because it reduces asymmetric information liquidity costs. The same liability formula applies for alternative targets of liability, such as the manager, and the approximate magnitude of the optimal fine remains the same; however, judgment-proofness and limited liability may militate toward firm-level fines.

Explaining the On-The-Run Puzzle with Corporate Bonds

The on-the-run phenomenon is regularly found in the bond markets. It refers to the phenomenon of the yield difference observed when a new bond issue comes to market from the same issuer and gets a better price (lower yield given equivalent duration) from the market than the older issue. This paper proposes and tests a liquidity model to explain phenomenon introducing entropy as our liquidity measure. The yield differential results from the illiquidity cost of the older issue that has increased as a result of progressing through stages, which typically occur in an entropy process. We find that a model employing an entropy measure largely explains the on-the-run phenomenon, by accounting for over three-quarters of the liquidity differential for on-the-run corporate bonds.

Forced Liquidations, Fire Sales, and the Cost of Illiquidity

Seeking diversification, institutional investors are often drawn to investment opportunities that are relatively illiquid, taking for granted that they will receive a liquidity premium that compensates them for the lack of liquidity. Forced liquidations typically occur when illiquid portfolios become overvalued relative to their true market value and the reported valuation is no longer credible. When a forced liquidation occurs, the significant associated costs are obvious and easy to take into account. But there is a rarely recognized cost that investors should apply to illiquid investments’ expected return before such an event. This article presents a simple option-adjusted return for evaluating the cost of such illiquidity.