Effects Of Illiquidity Research Articles

Challenges of Frontier Stock Markets with Low Liquidity: A Case Study of Ghana Stock Exchange

Very few studies examined the antecedents of illiquidity in the finance literatures. This research investigates factors contributing to the problem of illiquidity, a common feature of frontier markets, on the Ghana Stock Exchange (GSE). The general objective of the research was to analyze the illiquidity phenomena- its origins, impacts, and potential remedies. More specifically, the research focused on the effect of illiquidity on stakeholders and identified measures in place to improve the condition. The research adopted a qualitative methodology research with unstructured phenomenological interviews, which enabled participants to share experiences, opinions and perspectives on the problem. Twenty-two participants representing the major stakeholders on the market were selected for the study, including: (i) registered brokers; (ii) listed companies; (iii) unlisted companies; (iv) government institutions, (v) regulatory agencies, and (vi) investors. The results indicated that there is lack of equity culture in Ghana, with bank loans and personal savings being primary sources of business funding. Macro-economic instability also affects businesses and investors. Government borrowing at high treasuries interest rates makes stock market less attractive. The study also revealed that market inefficiencies, lack of clear government policy direction and effective regulation also contribute to illiquidity. To deal with the problem, the exchange has recently introduced the Ghana Alternative Market (GAX) for SMEs, and the Ghana Fixed Income Market (GFIM). Based on the findings, it is recommended that the government tackles anti-equity culture through financial literacy programs or education, and establish financial incentives for listed companies. Government must control borrowing through prudent fiscal policies, maintain macro-economic stability, and implement effective policies and regulations that promote listing of State Owned Enterprises (SOEs), local private companies and foreign businesses on the GSE.

German Mittelstand bonds: yield spreads and liquidity

We estimate a cross-sectional model of the yield spreads of German Mittelstand bonds as a function of liquidity measures as well as a number of variables that control for both the characteristics of the issuing firm and the bond characteristics. Our results show a significant positive effect of illiquidity on the yield spread, which persists after controlling for the risk of the bond. Economically, the size of the liquidity premium of Mittelstand bonds is approximately twice the size of speculative grade US corporate bonds. Our findings are robust to different measures of liquidity and potential endogeneity biases.

The Deterrence Effect of Stock Illiquidity on Mutual Fund Risk-Shifting: A Silver Lining

The Deterrence Effect of Stock Illiquidity on Mutual Fund Risk-Shifting: A Silver Lining

A Nonlinear Option Pricing Model Through the Adomian Decomposition Method

Recently the liquidity of financial markets and transaction costs have become a topic of great interest in financial risk management. In this paper, a hypotetical nonlinear model of option pricing that occurs when the effects of market illiquidity and transaction costs are taken into account and an approximate solution is obtained through the Adomian decomposition method. Finally, two numerical examples are investigated to demonstrate the efficiency of our approach.

Portfolio Dynamics and Expected Returns Under Illiquidity

Using a novel continuous-time framework, this paper explores the effects of illiquidity on portfolio dynamics and expected returns. In summary, the paper makes three key contributions to the existing literature on asset pricing and illiquidity. First, it illustrates that illiquidity leads to portfolio proportions being stochastic processes. The numerical results highlight that investors should be prepared for potentially large and skewed variations in portfolio weights and can be away from optimal diversification for a long time when adding illiquid assets to a portfolio. The second contribution is to show that stochastic portfolio proportions implied by illiquidity increase overall portfolio risk. Interestingly, this effect gets more pronounced when the return correlation between the liquid and illiquid asset is low. Thus, there is a correlation effect in the sense that illiquidity costs, as measured by the increase in overall portfolio risk due to portfolio proportions being stochastic, are inversely related to the return correlation of the liquid and illiquid asset. Third, the paper explores the asset pricing implications of stochastic portfolio proportions. The derived valuation framework shows that the required excess returns of a portfolio can be split into two covariance terms: the first covariance term captures standard market risk, whereas the second term can be interpreted as a required compensation for a form of liquidity risk. This required compensation for liquidity risk increases linearly with the covariance between the proportion invested illiquid in the portfolio and the proportion invested illiquid in the market portfolio, i.e., investors want to be compensated for holding portfolios that become illiquid when the market in general turns illiquid.

The Market(s) Left Behind: Price Formation in Municipal Secondary Trades

This study addresses the determinants of municipal secondary trade prices for state general obligation bonds issued during 2005-2010. I find that a two-component finite mixture model, as postulated in the hypothesis of price dispersion under market opacity, remains the best specification for the municipal secondary market. There are distinct pricing regimes that persist even after controlling for the effects of illiquidity, market segmentation, fixed costs, and market fundamentals. Consistent with the theory of information economics, some municipal transactions (predominantly smaller household trades) are facing inferior prices in the municipal OTC market. Moreover, trades in the more informed price regime appear to be facing prices that became even more favorable during and after the Great Recession, while trades in the less informed price regime appear to be worse-off during the same period.

The Real Effects of Liquidity During the Financial Crisis: Evidence from Automobiles

This paper shows that illiquidity in short-term credit markets during the financial crisis may have sharply curtailed the supply of non-bank consumer credit. Using a new data set linking every car sold in the United States to the credit supplier involved in each transaction, we show that the collapse of the asset-backed commercial paper market decimated the financing capacity of captive leasing companies in the automobile industry. As a result, car sales in counties that traditionally depended on captive-leasing companies declined sharply. Although other lenders increased their supply of credit, the net aggregate effect of illiquidity on car sales is large and negative. We conclude that the decline in auto sales during the financial crisis was caused in part by a credit supply shock driven by the illiquidity of the most important providers of consumer finance in the auto loan market: the captive leasing arms of auto manufacturing companies. These results also imply that interventions aimed at arresting illiquidity in credit markets and supporting the automobile industry might have helped to contain the real effects of the crisis.

Portfolio Optimization with Private Equity Funds

This paper extends the standard Merton portfolio choice model to include illiquid private equity funds. This is done in a realistic modeling framework where private equity funds cannot be traded during their entire bounded lifecycle and involve capital commitments and intermediate capital distributions that cannot be reinvested immediately. Assuming an investor that derives CRRA power utility from terminal portfolio wealth, the paper solves for a dynamic commitment and portfolio strategy that shows investors how to optimally commit capital to private equity funds and how to optimally rebalance between liquid stocks and bonds over time. The framework also allows directly studying the effects of illiquidity on optimal portfolio allocations and on investors' utilities. These results provide a number of important insights about the effects of illiquidity of private equity funds. Most importantly, the paper shows that liquidity associated welfare losses are negligible in case that private equity funds and traded stocks are relatively close substitutes, i.e. both have similar risk-return characteristics and a medium or high return correlation. This finding sheds new light on the discussion why many recent papers document that private equity funds only generate returns that are comparable to traded stocks despite being highly illiquid investments.

An Analysis of the Amihud Illiquidity Premium

This paper analyzes the Amihud (2002) measure of illiquidity and its role in asset pricing. It is shown first that the effect of illiquidity on asset pricing is clarified by using the turnover version of the Amihud measure and including firm size as a separate variable. When we decompose the Amihud measure into elements that correspond to positive (up) and negative (down) return days, we find that in general, only the down-day element commands a return premium. Further analysis of the up- and down-day elements using order flows shows that a sidedness variable, which captures the tendency for orders to cluster on the sell side on down days, is associated with a more significant return premium than the other components of the Amihud measure.

The Effect of Reliance on International Funding on Banking Fragility: Evidence from East Asia

The East Asian crisis highlights the importance of liquidity for smooth functioning of the banking system. It also shows the vulnerabilities that arise as a result of high dependence on international liquidity. This article empirically analyses the influx of liquidity before the crisis and illiquidity during the crisis in finding out whether banks in East Asia held ‘too little’ or ‘too much’ liquidity before and during a crisis and how their vulnerabilities to failure changed as a result of that. Instrumental Variable estimation is used to dissociate the effect of international illiquidity on banks’ liquidity risk during a crisis year. The study finds that the effect of liquidity on the probability of bank failure varies before and during a crisis. The findings also highlight the vulnerabilities of banks to failure as a result of international illiquidity and high reliance on external funding. These findings bring forward the case for stronger regulation of banks’ liquidity, which can be brought forward by better liquidity management.

On the appraisal of LVaR throughout the close-out period: an investment management outlook from recent global financial crisis

In this paper, we launch a practical modus-operandi for the assessment of potential market risk exposures for financial trading portfolios by providing an investment management perspective from recent global financial crisis. This proposed tactic is based on the renowned concept of Liquidity-Adjusted Value-at-Risk (LVaR) along with the innovation of a risk-engine algorithm that can estimate LVaR for both long and short-sales positions. Our wide-ranging risk model can conduct LVaR analysis under normal and severe market conditions besides it takes into account the effects of illiquidity of equity securities, under crisis-driven circumstances, throughout the close-out period. In order to clarify the accurate use of LVaR and stress-testing methods, real-world simulation scenarios of trading risk management are presented for the Gulf Cooperation Council (GCC) financial markets. The developed methodology and risk assessment algorithms can aid in advancing risk management practices in emerging markets and particularly in the wake of recent credit crunch.

Risk Management in Trading and Investment Portfolios

The aim of this article is to bridge the gap in equity trading risk management literatures and particularly from the perspective of emerging and illiquid markets, such as in the context of the Gulf Cooperation Council (GCC) financial markets. In this article, we demonstrate a practical approach for the measurement and control of market risk exposure for financial trading portfolios that contain several illiquid equity securities during the unwinding (close-out) period. This approach is based on the renowned concept of Value-at-Risk (VaR) along with the development of an optimisation risk algorithm utilising matrix-algebra technique. Our thorough asset market risk modelling-algorithm can simultaneously handle VaR analysis under normal and severe market conditions, besides it takes into account the effects of illiquidity and short-sales of traded equity securities. In order to illustrate the proper use of VaR and stress-testing methods, real-world structured modelling techniques of trading risk management are presented for the GCC financial markets. To this end, comprehensive simulation case studies are accomplished with the objective of constructing a realistic framework for trading risk measurement and control in addition to the instigation of a risk optimisation algorithm-process for the computation of maximum authorised VaR risk-budgeting limits. JEL Classification: C10, C13, G20, G28

An Analysis of the Amihud Illiquidity Premium

This paper analyzes the Amihud (2002) measure of illiquidity and its role in asset pricing. It is shown first that the effect of illiquidity on asset pricing is clarified by using the turnover version of the Amihud measure and including firm size as a separate variable. When we decompose the Amihud measure into elements that correspond to positive (up) and negative (down) return days, we find that in general, only the down-day element commands a return premium. Further analysis of the up and down-day elements using order flows shows that a sidedness variable, which captures the tendency for orders to cluster on the sell side on down days, is associated with a more significant return premium than the other components of the Amihud measure.

What 'Triggers' Mortgage Default?

This paper assesses the relative importance of two key drivers of mortgage default: negative equity and illiquidity. To do so, the authors combine loan-level mortgage data with detailed credit bureau information about the borrower's broader balance sheet. This gives them a direct way to measure illiquid borrowers: those with high credit card utilization rates. The authors find that both negative equity and illiquidity are significantly associated with mortgage default, with comparably sized marginal effects. Moreover, these two factors interact with each other: The effect of illiquidity on default generally increases with high combined loan-to-value ratios (CLTV), though it is significant even for low CLTV. County-level unemployment shocks are also associated with higher default risk (though less so than high utilization) and strongly interact with CLTV. In addition, having a second mortgage implies significantly higher default risk, particularly for borrowers who have a first-mortgage LTV approaching 100 percent.

Incorporating Liquidity Risk in Value-at-Risk Based on Liquidity Adjusted Returns

In this paper, based on Acharya and Pedersen’s overlapping generation model, we show that liquidity risk could influence the market risk forecasting through at least two ways. Then we argue that traditional liquidity adjusted VaR measure, the simply adding of the two risk measure, would underestimate the risk. Hence another approach, by modeling the liquidity adjusted returns (LAr) directly, was employed to incorporate liquidity risk in VaR measure in this study. Under such an approach, China’s stock market is specifically studied. We estimate the one-day-ahead “standard” VaR and liquidity adjusted VaR by forming a skewed Student’s t AR-GJR model to capture the asymmetric effect, non-normality and excess skewness of return, illiquidity and LAr. The empirical results support our theoretical arguments very well. We find that for the most illiquidity portfolio, liquidity risk represents more than 22% of total risk. We also find that simply adding of the two risk measure would underestimate the risk. The accuracy testing show that our approach is more accurate than the method of simply adding.

Commodity price risk management: Valuation of large trading portfolios under adverse and illiquid market settings

Given the rising need for measuring and controlling commodity price risk exposure, trading risk prediction under illiquid and adverse market conditions plays an increasing role in commodity and financial markets. The aim of this paper is to close the void in commodity trading risk management literature, particularly from the perspective of large trading portfolios, by illustrating how the modified Value-at-Risk (VaR) method can be used by a commodity trading unit in reporting risk exposure, assessing risk reduction alternatives and setting optimised risk limits. In this study we put forward a re-engineered VaR model relevant for commodity trading units that have long- and short-selling trading positions and suggest potential applications of VaR in the context of commodity risk management. To the best of our knowledge, this is the first research paper that addresses the issue of liquidity trading risk management in commodity markets with direct applications to a larger portfolio of distinctive assets. This paper provides real-world techniques and realistic asset allocation strategies that can be applied to commodity trading portfolios in illiquid markets and under adverse market conditions. The modelling technique is based on the renowned concept of liquidity-adjusted VaR (L-VaR), along with the creation of a software tool utilising matrix-algebra techniques. As such, our comprehensive risk model can simultaneously handle market risk analysis under normal and severe market settings as well as take into account the effects of illiquidity of traded commodities. In order to illustrate the proper use of L-VaR under stressed and illiquid market conditions, real-world examples and feasible reports of liquidity trading risk management are presented for a portfolio of 25 distinct commodities, within a multivariate context and under the notion of several correlation factors along with different liquidity horizons. The example and discussions are widely applicable to any commodity end-user, providing potential applications to practitioners and research ideas to academics.

Stock and Bond Market Liquidity: A Long-Run Empirical Analysis

AbstractThis paper establishes liquidity linkage between stock and Treasury bond markets. There is a lead-lag relationship between illiquidity of the two markets and bidirectional Granger causality. The effect of stock illiquidity on bond illiquidity is consistent with flight-to-quality or flight-to-liquidity episodes. Monetary policy impacts illiquidity. The evidence indicates that bond illiquidity acts as a channel through which monetary policy shocks are transferred into the stock market. These effects are observed across illiquidity of bonds of different maturities and are especially pronounced for illiquidity of short-term maturities. The paper provides evidence of illiquidity integration between stock and bond markets.

Stock and Bond Market Liquidity: A Long-Run Empirical Analysis

This paper establishes liquidity linkage between stock and Treasury bond markets. There is a lead-lag relationship between illiquidity of the two markets and bi-directional Granger causality. The effect of stock illiquidity on bond illiquidity is consistent with flight-to-quality or flight-to-liquidity episodes. Monetary policy impacts illiquidity. The evidence indicates that bond illiquidity acts as a channel through which monetary policy shocks are transferred into the stock market. These effects are observed across illiquidity of bonds of different maturities and are especially pronounced for illiquidity of short-term maturities. The paper provides evidence of illiquidity integration between stock and bond markets.

Marketability and Value: Measuring the Illiquidity Discount

Should investors be willing to pay higher prices for more liquid assets than for otherwise similar assets that are less liquid? If the answer is yes, how much should the premium be for liquid assets? Conversely, how do we estimate the discount for illiquid assets? In this paper, we argue that it is a mistake to think of some assets as illiquid and others as liquid and that liquidity is a continuum, where some assets are more liquid than others. We then examine why liquid assets may be priced more highly than otherwise similar illiquid assets and why some investors value liquidity more than others. We follow up be presenting the empirical evidence that has accumulated over time and across different assets - financial and real - on the cost of illiquidity. Finally, we consider how we can use the theory and evidence on illiquidity to estimate the effect of illiquidity on the value of an asset or business.

The practice of investment valuation in emerging markets: Evidence from Argentina

This paper discusses the challenges of applying traditional valuation techniques to emerging markets, and reports on how CFOs, financial advisors and private equity funds meet those challenges in Argentina, a major Latin American emerging economy. On many fronts, our findings show that there is substantial alignment with U.S. valuation practices. We find that: (a) discounted cashflow techniques like NPV, IRR and payback are very popular among corporations and financial advisors; (b) the CAPM is the most popular asset pricing model, yet it is frequently modified to account for country-specific risk; (c) capital budgeting analyses are performed in U.S. dollars by non-dollar companies; (d) financial advisors tend to apply U.S. betas to the emerging market, yet they rarely adjust betas for cross-border asymmetries; and (e) corporations tend to disregard the effects of small size and illiquidity. We provide tentative explanations for our findings.