Equity Market Liquidity Research Articles

Hedging Credit: Equity Liquidity Matters

Credit default swap (CDS) spreads are directly related to equity market liquidity in the Merton (1974) model via hedging. This relationship is monotone increasing when credit quality worsens. Empirical tests confirm this relationship. We theorize and confirm this new channel by means of which liquidity costs are embedded in CDS spreads.

Evidence on board size and information asymmetry: A capital markets perspective

We examine the relation of board size with market liquidity and adverse selection costs using a sample of Fortune 200 companies. After controlling for firm specifics, equity characteristics, and ratio of insiders, we find a direct relation between board size and equity market liquidity. Our findings indicate that board size is positively and significantly related to dollar depth but has no impact on bid-ask spreads. Furthermore, using the adverse selection component of the bid-ask spread as a proxy for transparency, we find that larger boards reduce information asymmetries, but the ratio of insiders to total board members has no impact on informational asymmetries

Liquidity and Capital Structure

We examine the relation between equity market liquidity and capital structure. We find that firms with more liquid equity have lower leverage and prefer equity financing when raising capital. For example, after sorting firms into size quintiles and then into liquidity quintiles, the average debt-to-asset ratio of the most liquid quintiles is about 38% while the average for the least liquid quintiles is 55%. Similar results are observed in panel analyses with clustered errors and using instrumental variables. Our results are consistent with equity market liquidity lowering the cost of equity and, therefore, inducing a greater reliance on equity financing.

Credit Ratings and Stock Liquidity

We analyze contemporaneous and predictive relations between credit ratings and measures of equity market liquidity and find that common measures of adverse selection, which reflect a portion of the uncertainty about future firm value, are larger when credit ratings are poorer. We also show that future rating changes can be predicted using current levels of adverse selection. Collectively, our results validate widely used microstructure measures of adverse selection and offer new insights into the value of credit ratings and the specific nature of the information they contain. Copyright 2006, Oxford University Press.

Liquidity Risk Premia in Corporate Bond Markets

This paper explores the role of liquidity risk in the pricing of corporate bonds. We show that corporate bond returns have signifcant exposures to fluctuations in treasury bond liquidity and equity market liquidity. Further, this liquidity risk is a priced factor for the expected returns on corporate bonds, and the associated liquidity risk premia help to explain the credit spread puzzle. In terms of expected returns, the total estimated liquidity risk premium is around 0.6% per annum for US long-maturity investment grade bonds. For speculative grade bonds, which have higher exposures to the liquidity factors, the liquidity risk premium is around 1.5% per annum. We find very similar evidence for the liquidity risk exposure of corporate bonds for a sample of European corporate bond prices.

Credit Ratings and Stock Liquidity

We analyze contemporaneous and predictive relations between debt ratings and measures of equity market liquidity, and find that common measures of adverse selection, which reflect a portion of the uncertainty about future firm value, are larger when debt ratings are poorer. This relation holds even after controlling for many other observable factors. We also show that ratings changes can be predicted using current levels of adverse selection, which suggests that credit rating agencies sometimes react slowly to new information. Collectively, our results offer new insights into the value of debt ratings, the specific nature of the information they contain, and the speed with which they reflect changes in uncertainty.