Higher Illiquidity Research Articles

How does informed trading affect credit bond spreads: Evidence from China's interbank bond market

China's interbank bond market is an institutional investor market, and transactions are more information-based. Whether and how informed trading can affect credit bond pricing is an urgent problem to be solved in the study of China's bond asset pricing. This paper uses credit bond issuance and trading data and stock high-frequency trading data from May 2014 to December 2020 to construct informed trading probability and bond liquidity indicators. Using regression analysis and adjustment and mediation effect test methods, this paper studies the impact of informed trading on China's interbank credit bond pricing and the channel role of liquidity. The results show that the probability of informed trading has a significant positive impact on credit bond spreads. Informed trading leads to an increase in credit bond spreads by amplifying bond illiquidity. The amplifying effect of informed trading on credit bond spreads is stronger for bonds with high illiquidity. The amplifying effect of informed trading on credit bond spreads will be stronger in private enterprises, enterprises with low information transparency, and high debt ratios. This study reveals the risk nature of informed trading in China's interbank bond market, which helps to deepen the understanding and management of the bond market.

Digital payment, money market fund and investment behavior

Does digital payment affect the flow patterns in money market funds? In recent years, some money market funds (MMFs) have been introduced to digital payment platforms. The users can hold these MMFs and directly use them for transactions. This additional liquidity may influence investor behavior. Using individual-level data from the world's largest digital payment platform Alipay, this paper investigates the impact of digital payment on flow patterns in MMFs. We show that compared with traditional MMFs, the MMFs combined with digital payment are more attractive to investors, and flows in these MMFs are less sensitive to their past performances. Furthermore, in the period with high illiquidity, digital payment decreases the outflows from MMFs, indicating that digital payment potentially decreases liquidity risk and enhances the stability of the money market.

Tail risks and private equity performance

We examine the drivers of private equity in response to the fully exogenous Covid-19 shock, employing listed private equity as a proxy for traditional non-listed private equity. This approach enables us to reliably measure firm characteristics and performance in real-time. Listed private equity firms, on average, underperformed significantly during the crisis, with a performance drop ranging from 9.2 % to 43.6 %, depending on the model used. However, there is substantial cross-sectional variation driven by unique firm-level attributes including access to capital, liquidity, transparency, and ownership structure. Listed private equity with better access to capital and higher transparency shows resilience during the crisis, while higher illiquidity and opacity exacerbate the negative effects. This study offers early evidence on Covid-19′s impact on private equity firms, highlighting value drivers and performance dynamics of this alternative asset class during a period of extreme tail risk.

DETERMINANTS OF THE PROFITABILITY OF BANKING SECTOR IN TURKEY

The profitability of banks is an important subject around the world, since the banking system is a vital component in any economy, thus interests many parties including investors and regulatory bodies. This study aims to shed light to the factors that affect the profitability of banks in Turkey across bank types using the annual data for the banks in Turkey between 2004 and 2017. Overall, credit riskiness, funding cost and GDP growth has a positive effect and operating cost has a negative effect on bank profitability. Higher illiquidity, funding cost and operating cost significantly positively affects profitability for large, private and foreign banks but not for state banks. Labor productivity however, while significantly positively affects profitability for foreign banks, it has a negative effect on profitability for large and private banks. The findings suggest important regulatory suggestions for the banking and finance system.

Sitting bucks: Stale pricing in fixed income funds

We find evidence of widespread stale pricing in bond mutual funds and the resulting risks of dilution and fragility. A principal driver of this phenomenon is the high illiquidity of funds’ holdings, which makes accurate pricing difficult and provides funds with greater discretion over valuation. Consequently, net asset values (NAVs) are extremely stale and fund returns are predictable over several days and weeks, particularly during market crises. Opportunistic traders withdraw capital from overvalued funds, exacerbating the risk of fund runs, while buy-and-hold investors face annual dilution of around $1.2 billion. Our results highlight adverse consequences of insufficient fair valuation practices that remain pervasive even after corrective regulations that followed the 2003 market-timing scandal.

Crisis Management Strategies of Startups in the COVID-19 Pandemic

The survival and growth of entrepreneurial startups system are threatened by the unprecedented exogenous shock of the COVID-19 pandemic. While startups play pivotal roles in a country’s national innovation system, “what, why, and how” they act against the crisis has remained an underexplored topic. This study aims at identifying specific government policy initiatives to protect the firms’ survival during the crisis and counterstrategies employed by startups in the crisis management processes. Our quantitative analysis of 91 policy initiatives in 40 countries against the COVID-19 economic crisis indicates that governments focus mainly on providing short-term financial supports such as interest/tax benefits, payment delays, and wage subsidies for small and medium-sized enterprises. In contrast, startup-specific supports buffering from the lack of investment and financial capital were insufficient. Another qualitative analysis of interviews with 16 actors in entrepreneurial ecosystems reveals that Korean startups are leveraging the productive utilization of available resources through business model improvements, organizational restructuring, and external networks against the high illiquidity caused by the crisis. Startups are also required to remain resilient in the entrepreneurial crisis management process by adopting bricolage responses allowing high agility and adaptability for seeking alternative business opportunities in times of crisis.

Intraday Market Predictability: A Machine Learning Approach

Conducting, to our knowledge, the largest study ever of five-minute equity market returns using state-of-the-art machine learning models trained on the cross-section of lagged market index constituent returns, we show that regularized linear models and nonlinear tree-based models yield significant market return predictability. Ensemble models perform the best across time and their predictability translates into economically significant Sharpe ratios of 0.98 after transaction costs. These results provide strong evidence that intraday market returns are predictable during short time horizons, beyond what can be explained by transaction costs. Furthermore, we show that constituent returns hold significant predictive information that is not contained in market returns or in price trend and liquidity characteristics. Consistent with the hypothesis that predictability is driven by slow-moving trader capital, predictability decreased post-decimalization, and market returns are more predictable during the middle of the day, on days with high volatility or illiquidity, and in financial crisis periods.

Overlapping Narrative Risk Disclosures and Return Predictability

We use unsupervised machine learning techniques of natural language processing to measure the semantic relatedness of firms’ narrative risk disclosures (NRD) in the “risk factor” section of their annual reports. We find strong return predictability among firms with overlapping NRD. This momentum effect is distinct from return predictability due to existing factors such as industry momentum, complexity of firm operations, and size-based information diffusion. A long-short strategy based on the NRD relatedness yields a monthly alpha of 70 basis points. Further analyses show that this lead-lag return effect is stronger among firms with lower investor attention and higher illiquidity. Our findings highlight important asset pricing implications of textual relatedness in NRD that investors seem to be inattentive towards.

Is Illiquidity Priced in the Chinese Stock Market?

Although liquidity has received wide attention in asset pricing literature over the past decades, how stock liquidity is priced in emerging markets remains unclear. We find that liquidity plays an important role in explaining the cross-section and time-series variation in expected returns by incorporating multi-dimensional liquidity proxies in the spread, depth, and trading activity. The predictive power persists after controlling the several conventional pricing factors. We also find that the high illiquidity quintile generates higher monthly risk-adjusted returns than the low illiquidity quintile, ranging from 3.2% to 8.4% per month. The results are robust to alternative stock liquidity measures and sampling criteria. Our findings highlight the profitability of liquidity-based trading strategy in the Chinese stock market.

How is Liquidity Priced in Global Markets?

Abstract We develop a new global asset pricing model to study how illiquidity interacts with market segmentation and investability constraints in 42 markets. Noninvestable stocks that can only be held by foreign investors earn higher expected returns compared to freely investable stocks due to limited risk sharing and higher illiquidity. In addition to the world market premium, on average, developed and emerging market noninvestables earn an annual unspanned local market risk premium of $1.17\%$ and $9.04\%$, and a liquidity level premium of $1.06\%$ and $2.39\%$, respectively. These results obtained in a conditional setup are robust to the choice of liquidity measure.

Measuring liquidity in Indian stock market: A dimensional perspective.

Market liquidity ensures the marketability of security and is an indispensable feature of stock markets. Previous studies have emphasized the role of stock market liquidity in empirical finance. However, they have inadequately explored its multidimensional nature. This study eliminates the ambiguities related to market liquidity by precisely measuring it by using popular and proven liquidity measures. As such, the present study aims to evaluate market liquidity in terms of depth, breadth, tightness, and immediacy in the Indian equity market and also identifies crucial interdependencies between liquidity dimensions. The study selects 500 stocks constituting the NIFTY 500 index of the National Stock Exchange, India, as of 26th May 2019. The data on trading volume, bid price, ask price, the number of shares outstanding, closing share prices were retrieved for the period from 1st April 2009 to 31st March 2019. The study employs Share Turnover, Amihud Illiquidity Ratio, Relative Quoted Spreads, and Coefficient of Elasticity of Trading for liquidity measurement. The Vector Auto-Regressive (VAR) model is used to establish the simultaneous relationships between liquidity dimensions. The analysis is conducted at the aggregate market level as well as across turnover based stock groups divided based on their rankings in terms of stock specific share turnover. The empirical results evidenced the presence of consistent depth, strong breadth, and immediacy but lower tightness in the Indian equity market. The market depth and tightness appear to be relevant in determining dimensional interdependencies. Also, less frequently traded stocks exhibit higher illiquidity in the wake of lower tightness. The findings of this study will assist the investors to wisely understand the multifaceted nature of market liquidity and base their trading decisions accordingly. Moreover, the regulators of the stock exchange can devise liquidity enhancing policies based on the directional movements among liquidity dimensions.

It takes two to tango: Fundamental timing in stock market

AbstractIn this paper, we propose a fundamental timing strategy in both U.S. and Chinese stock markets to timing the fundamentals sorted portfolios such as value and profitability portfolios in the time‐series dimension. We find that fundamental timing strategies based on moving average (MA) timing signals could generate substantial performance gains relative to buy‐and‐hold strategies. The annualized average return of fundamental timing strategies reaches about 37% with Sharpe ratio nearly 1.30. These findings are robust to Fama–French factor model adjustment, alternative lag lengths of MA signals, holding days, and transaction costs. Moreover, the fundamental timing premium cannot be explained away by market timing or business cycle, and fundamental timing is more profitable among firms with high idiosyncratic volatility and high illiquidity.

Hedging the Art Market: Creating Art Derivatives

A number of inefficiencies in the art market stress the fact that art remains a highly risky investment. The art market is characterized by high illiquidity, inefficient market information, high transaction costs, long transaction time and the absence of a hedging mechanism. Therefore, unlike investments in other sectors, investors cannot calculate the risk and return profile of art. More importantly, this currently makes it very difficult to hedge, or protect against possible losses. Applying a hedging strategy to art will bring the liquidity and regulation needed as well as stimulate future investment. This dissertation will explore the opportunity for derivative products in art. In order to create a 'true' hedge for art, derivatives with art as the 'underlying' should be developed. I propose a model for a total return art swap which will allow investors to protect themselves against movements in the art market. The need for tradable art indexes, which are crucial for the successful creation of art derivatives, will also be discussed. These aims will be achieved by exploring the recent emergence of property derivatives due to its marked resemblance as an asset class. In my study, I find that art derivatives have enormous market potential. They can bring liquidity and efficiency to the market and provide numerous benefits to investors. These potential benefits include removing the high transaction costs associated with art purchases, limited start-up cost with a low financial commitment, customized transactions and quick executions. A discussion surrounding derivatives is particularly relevant amid the recent financial turmoil since investors are reminded of the advantages of hedging. Art derivatives can revolutionize the art market by offering a simpler and easier way to manage the risk and return of art. My hope is that this paper will begin a debate among the worlds of art and finance on the advantages of creating art derivatives.

It Takes Two to Tango: Fundamental Timing in Stock Market

In this paper, we propose a fundamental timing strategy in both U.S. and Chinese stock market to trade the fundamental sorted portfolios such as value and profitability portfolios in the time series dimension. We find that fundamental timing strategies based on moving average (MA) timing signals could generate substantial performance improvements relative to corresponding buy-and-hold fundamental strategies. The annualized average return of the 20-day MA fundamental timing strategies reaches about 37% with Sharpe ratio nearly 1.30. These findings are robust to Fama-French factor model adjustment, alternative lag lengths of MA signals, holding days, and transaction costs. Moreover, we find that the fundamental timing premium cannot be explained by market timing ability or business cycle, and fundamental timing is more profitable among firms with high idiosyncratic volatility and high illiquidity measures.

Sitting Bucks: Zero Returns in Fixed Income Funds

We document evidence of widespread stale pricing in bond mutual funds and the resulting risks of dilution and fragility. A principal driver of this phenomenon is the high illiquidity of funds’ holdings, which makes accurate pricing difficult and provides funds with greater discretion over valuation. Consequently, net asset values (NAVs) are extremely stale and fund returns are predictable over several days and weeks, particularly during market crises. Opportunistic traders withdraw capital from overvalued funds, exacerbating the risk of fund runs, while buy-and-hold investors face annual dilution of around $1.2 billion. Our results highlight adverse consequences of insufficient fair-valuation practices that remain pervasive even after corrective regulations that followed the 2003 market-timing scandal.

Air pollution, stock returns, and trading activities in China

The relationship between air pollution and stock pricing of locally headquartered firms is explored using firm-level data in China. Severe air pollution results in low returns, turnover, volatility, and high illiquidity, mainly through a home bias. The results remain robust after a series of checks. The relation between air pollution and local firm performance is insignificant, implying that the air pollution effects can be attributed to investor mood bias rather than to economic effects. The sensitivity of stock returns to air pollution is significantly large for high-growth stocks, distressed stocks, and stocks with high volatility.

Alternatives to Alternative Assets: Applications of S&P 500 Index Option Based Strategies

Hedge Funds should deliver good risk-adjusted returns and provide diversification for investors’ portfolios. However, the performance of hedge funds deteriorated in recent years and many investors may not be suitable to invest in hedge funds due to their high costs, illiquidity, and lack of transparency. The focus of this study is to examine whether equity index option-based strategies may deliver the same coveted ideal hedge fund return characteristics, i.e., good risk adjusted returns, mitigated risk measures, and added diversification. A total of seven S&P 500 Index based generic option-writing strategies, named CP100 to CP0, are analyzed and compared with a comprehensive set of 14 Credit Suisse hedge fund indexes using volatility or beta as matching metrics. The three series of CP100, CP80, and CP50, can be viewed as a solid suite of liquid alternatives to hedge funds. They match the 14 Credit Suisse hedge fund indexes on beta levels but deliver better risk-adjusted returns. Their annual returns and risk measures are better than or on par with the hedge fund indexes with the exception of the Credit Suisse Global Macro Index, which may be matched by a levered version of the CP100 option strategy. This suite of three option strategies are transparent, liquid, inexpensive, and easy to implement. They can achieve the same goals of hedge funds: attractive risk-adjusted returns, subdued risks, and added diversification. They may play multiple and important roles in institutional investors’ portfolios.

Is Liquidity Risk Priced in Partially Segmented Markets?

We develop a new global asset pricing model to study how illiquidity interacts with market segmentation and investability constraints in 42 markets. Non-investable stocks that can only be held by foreign investors earn higher expected returns compared to freely investable stocks due to limited risk sharing and higher illiquidity. In addition to the world market premium, on average, developed and emerging market non-investables earn an annual unspanned local market risk premium of 1:17% and 9:04%, and a liquidity level premium of 1:06% and 2:39%, respectively. These results obtained in a conditional setup are robust to the choice of liquidity measure.

Political Uncertainty and Sovereign Bond Markets

This paper analyzes the effects of political uncertainty on prices and liquidity of sovereign bonds. We focus on the time period of the European sovereign debt crisis and on Italian government bonds. We study the effect of Euro, G8 and G20 summits together with relevant elections. Focusing on Italy allows us to analyze a major European government bond market based on detailed transaction data, which was highly affected by the sovereign debt crisis. In line with the theoretical literature, we find a significant drop in prices in combination with high illiquidity and sell-side pressure before the event. Prices and trading activity start to recover approximately one month after the event when the impact uncertainty of policy changes resolves. The effects are stronger when uncertainty - measured by the EPU index - is high and the economic conditions are perceived as being weak.

Currency devaluations, aggregate demand, and debt dynamics in economies with foreign currency liabilities

ABSTRACTThe article uses a post Kaleckian model to analyze how currency devaluations affect aggregate demand and capital accumulation in an economy with foreign currency liabilities in the short-run. In benchmark post Kaleckian open economy models, currency devaluations have two effects. First, they change international price competitiveness and thus affect net exports. Second, devaluations change income distribution and thereby affect consumption and investment demand. The overall effect on aggregate demand and investment is ambiguous and depends on parameter values. Existing models, however, disregard balance sheet effects that arise from foreign currency-denominated external debt. The article develops a novel post Kaleckian open economy model that introduces foreign currency-denominated external debt and balance sheet effects to examine the demand-effects of devaluations. Furthermore, the article models the dynamics of external and domestic corporate debt. It discusses how an economy may end up in a vicious cycle of foreign-currency indebtedness and derives the conditions under which indebtedness becomes stable or unstable. It shows that the existence of foreign currency-denominated debt means that contractionary devaluations are more likely, and that foreign interest rate hikes, and high illiquidity and risk premia compromise debt sustainability. Devaluations only stabilize debt ratios if they succeed in boosting domestic capital accumulation.