Illiquid Portfolios Research Articles

Momentum, reversals and liquidity: Indian evidence

This paper addresses three interesting questions. First, we explore whether price momentum exists for equities listed on the Bombay Stock Exchange (BSE). Second, whether liquidity (measured by turnover ratio) enhances the momentum effect. Third, whether momentum profits exhibit reversals for illiquid stocks. Using a large sample of 3956 stocks for the period 2000 to 2021, we establish three key results. First, we find evidence of significant price momentum (intermediate and long-term) for equities listed on the BSE. Second, when conditioned on liquidity, we find that the momentum returns (short, intermediate, and long-term) are more significant for the most liquid portfolio and exhibit persistence for the next 12 months. Third, although we document evidence of short and intermediate-term reversals among the most illiquid portfolios, we fail to find evidence of persistence. Our results continue to hold after controlling for risk factors related to market premium, firm size, value, and a host of macroeconomic indicators. Taken together, our paper highlights the role of liquidity in amplifying the momentum effect in the Indian market.

Economic policy uncertainty and illiquidity return premium

In this study, we examine the relation between the price of liquidity, or illiquidity return premium, and the economic policy uncertainty (EPU). On average, an illiquid portfolio earns a 0.597% higher monthly return than a liquid portfolio. The results further show that the EPU index has a positive relationship with the illiquidity return premium. This indicates that investors require higher compensation for holding illiquid stocks when there is a higher economic uncertainty. We also show that EPU affects the illiquidity return premium through the market illiquidity channel. The rise of EPU could increase the risk of illiquid stocks and make investors more risk-averse, thereby requiring higher compensation for illiquidity. Finally, it is found that the relationship between EPU and the illiquidity return premium is stronger when market liquidity is impaired and during crises.

Financial Fragility Across Europe and the US: The Role of Portfolio Choices, Household Features and Economic-Institutional Setup

This paper investigates households’ financial fragility in twelve European countries and in the US by employing the first wave of the Household Finance and Consumption Survey (HFCS) and the 2010 Survey of Consumer Finances (SCF), respectively. Financial fragility is defined by taking into account both income constraints and portfolio composition (liquidity and indebtedness). Three main results emerge. First, the estimation of bivariate probit models reveals that in all countries holding an illiquid portfolio increases the likelihood of being financially fragile, while having a mortgage generally reduces it. Second, there are relevant differences among countries in their estimated average probability of financial fragility. Finally, decomposition of these differences by means of counterfactual methods provides evidence of a significant role of the country’s economic-institutional setup in providing a safety net against financial fragility. This is more true in Europe than in the US.

Can Liquidity be a Risk Factor that Predicts Economic Growth?:The U.S. and International Evidence

We examine whether illiquidity premium, constructed as a difference in returns between the most illiquid and the least illiquid (or the most liquid) portfolios, predict future economic growth, measured by GDP growth rate. We find supporting evidence that the premium significantly predict future GDP growth rate in the U.S. even with various controls such as HML, SMB, dividend yield, industrial production, term premium, and default premium. Our empirical evidence provides new rational for why liquidity, a stock characteristic, is priced - since it has information about future real economy. However, contrast to the U.S. results, empirical evidence is mixed and generally weaker in the global sample of stocks from 35 countries.

Turnover Based Illiquidity Measurement as Investment Strategy on Zagreb Stock Exchange

This paper deals with illiquidity measurement of stocks on Croatian Stock market. Illiquidity measures used in this paper are daily ratio of absolute stock return to its dollar volume (ILLIQ) and RCT (Relative change in turnover). Aim of this paper is to show that illiquidity measure RCT makes clear distinction between liquid and illiquid stocks that should be reflected through investment strategy where investment in RCT based illiquid portfolios outperforms investment in ILLIQ based portfolios and CROBEX index. Research was carried out on eighteen stocks from Zagreb Stock Exchange (ZSE) which are constituents of CROBEX index. Portfolios of liquid and portfolios of illiquid stocks based on results of illiquidity measurement were constructed. Behaviour in terms of return and volatility of these portfolios in following one-year period was observed. Results showed that portfolios formed using RCT as measure of illiquidity constantly outperformed CROBEX index and ILLIQ based portfolios. Returns of RCT based portfolios had lower standard deviation and were more stable than ILLIQ based portfolios in whole period. RCT as a measure of illiquidity produces valuable information on stock liquidity that can be exploited as investment strategy reflecting itself in larger expected returns of RCT portfolios in future period than expected returns of ILLIQ based portfolios and market.

Financial constraints, stock liquidity, and stock returns

This paper examines stock liquidity in explaining the mixed relations between financial constraints and stock returns and the pricing of stock liquidity across financially constrained and unconstrained firms. We find a negative relation in liquid portfolios and a positive relation in illiquid portfolios. Financially constrained firms have higher liquidity risk and earn a higher illiquidity premium than unconstrained firms. Financial constraints cannot be independently priced in stock returns and can only be priced in conjunction with stock liquidity in bad economic times. Stock liquidity is independently priced for financially constrained firms or in good times, but not for unconstrained firms.

The Time Variation of Liquidity Risk on US Stock Markets

Abstract The influence of liquidity costs and liquidity risk on asset returns has been proven by several empirical studies. This paper analyzes the conditional version of the liquidity-adjusted capital asset pricing model and shows that betas significantly vary over different economic regimes and that liquid portfolios provide diversification benefits compared with illiquid portfolios. The results support the effects of a flight-to-liquidity. The time variation of liquidity betas induces additional risk for investors, which has important implications for investment decisions and asset allocation. Die Zeitschwankung des Liquiditatsrisikos in US-Aktienmarkten Zusammenfassung Der Einfluss von Liquiditatskosten und Liquiditatsrisiko auf die Renditen verschiedener Assets wurde bereits durch einige Studien belegt. Dieses Paper untersucht das conditional liquidity-adjusted capital asset pricing model und zeigt, dass die Liquidity-Betas signifikant uber verschiedene Marktphasen hinweg schwanken und dass liquide P...

Portfolio valuation under liquidity constraints with permanent price impact

When institutional investors rearrange their portfolios, they should consider both the temporary and the permanent price impacts. After a temporary price impact the order book fully recovers, whereas a permanent price impact changes the equilibrium price, having effects on the resulting portfolio.In this paper, for a given period, we introduce an optimization problem for valuing illiquid portfolios with permanent price impacts. We show how to find the optimal trade to satisfy certain portfolio constraints. As a policy implication, we note that introducing permanent price impacts in internal or external regulation can substantially change liquidity risk or capital requirements.

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.

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.

Profit Analysis of Short Term Weekly Momentum Strategy in the Korean Stock Market

This paper shows the momentum strategies that selected stocks based on their returns from a past 1 week generate long lasting significant abnormal returns. I observe the negative momentum profit from 1 week momentum portfolio and it disappears when the holding period is longer than 22 week. In addition, I empirically shows that the weekly momentum strategies are able to generate negative profits also after the financial crisis. it is opposite result with literature, reported positive momentum after the financial crisis, I realize this result due to the characteristic of short term weekly momentum and market adjust returns. The price limit is one of the big features of Korean stock market. I consider the set of sample period by change of price limit. I find the positive momentum profits only in the period of narrow price limit range. For the check on the relation between liquidity and profit of momentum strategy, I employ the illiquid measure of Amihud (2002). I find that the strong and long lasting negative momentum profit from illiquid stock portfolio. This result implied that liquidity enhances the profit of momentum.

Practical Applications of Do You Know What’s in Your Benchmark?

While building benchmarks against which to measure their portfolios can be a straightforward process for most practitioners, this isn’t the case for managers of illiquid portfolios. Practitioners and academics may be unknowingly exposing themselves to problematic assumptions contained in the underlying benchmark return methodology used by the <b>Center for Research in Security Prices (CRSP)</b>. This <b><i>Practical Applications</i></b> report highlights three main problems identified by the authors of <b><i>Do You Know What’s in Your Benchmark?</i></b>, from the Spring 2013 issue of <b><i>The Journal of Portfolio Management</i></b>. “These current issues with the benchmarks weren’t necessarily relevant when CRSP started in the sixties,” <b>Richard Price</b>, Assistant Professor of accounting at the <b>John S. Huntsman School of Business at Utah State University</b>, says in an interview. Prices co-authored the article with <b>Steven Crawford</b>, Assistant Professor of accounting at <b>Rice University’s Jones Graduate School of Business</b> in Houston and <b>James Hansen</b>, Assistant Professor of accounting at the <b>University of New Mexico’s Anderson School of Management</b>. <b>TOPICS:</b>Financial crises and financial market history, exchange-traded funds and applications, real estate

Effects of Liquidity Management on the Security Market Performance of Companies Listed at the Nairobi Securities’ Exchange

In order to evaluate the effects of liquidity management on the security market performance of companies listed at the Nairobi Securities Exchange, this Census study was carried out on the companies that are listed at the NSE over a 72-month period of January 2008 through December 2013. Using the descriptive research design and the Ordinary Least Squares (OLS) model the study revealed that there is a significant difference between the market performance of liquid companies and that of the illiquid companies, with quick ratio as the measure of liquidity management. Further, the study revealed that liquidity management has an effect on the market return/ performance albeit for the illiquid companies. From the study findings, the liquid portfolio excess return is significantly higher than the illiquid portfolio excess return. This could possibly be because the liquid portfolio companies are very risky while the illiquid portfolio companies are less risky as confirmed by the variations in the coefficient of variation. Because of the failure to influence market performance of liquid companies it was observed that the effect of liquidity management on the market performance of companies listed at the NSE increases with the level of illiquidity. Despite this finding, the study also revealed that all the companies that were studied had a quick ratio of above 1, an indication that they tie a lot of their money in liquid assets. It is recommended that the results of this study should be interpreted diligently because the study focused at a short period of only 72 months and a longer period could yield different results.

Hedge fund liquidity and performance: Evidence from the financial crisis

We investigate how share restrictions affect hedge fund performance in crisis and non-crisis periods. Consistent with prior research, we find that in the pre-crisis period more illiquid funds generate a share illiquidity premium compensating investors for limited liquidity. In the crisis period, this share illiquidity premium turns into an illiquidity discount. Hedge funds with more stringent share restrictions invest more heavily in illiquid assets. While share restrictions enable funds to manage illiquid assets effectively in the pre-crisis period, they seem insufficient to ensure effective management of illiquid portfolios in the crisis. In a crisis period, funds holding illiquid portfolios experience lower returns and alphas, also when share restrictions are controlled for. Funds with an asset–liability mismatch perform particularly poorly and experience the strongest outflows. Share restrictions are also a proxy for incentives as investors cannot immediately withdraw their money after poor performance. We show that higher incentive fees can offset the share illiquidity discount in the crisis period.

Hedge Fund Liquidity and Performance: Evidence from the Financial Crisis

In this paper, we investigate how share restrictions affect hedge fund performance in crisis and non-crisis periods. Consistent with prior research, we find that more illiquid funds produce both higher returns and alphas in the pre-crisis period. Hence, funds generate a share illiquidity premium for investors as a compensation for limited liquidity. In contrast, in the crisis period, this share illiquidity premium turns into an illiquidity discount. Hedge funds with more stringent share restrictions invest more heavily in illiquid assets. While share restrictions enable funds to manage these illiquid assets effectively in the pre-crisis period, they do not seem to be sufficient to ensure effective management of illiquid portfolios in a crisis. In a crisis period, funds holding illiquid portfolios experience lower returns and alphas, also when share restrictions are controlled for. Funds with an asset-liability mismatch, i.e., funds holding illiquid asset portfolios combined with weak share restrictions, perform particularly poorly and experience the strongest outflows in a crisis. However, share restrictions are not only a proxy for asset portfolio liquidity but also for incentives. Funds with stronger share restrictions and greater managerial discretion have fewer incentives to perform better because investors cannot immediately withdraw their money after poor performance. We show that hedge funds with stricter share restrictions and higher incentive fees do not experience a share illiquidity discount in the crisis period.

The Liquidity and Stock Returns: Empirical Evidence in Thailand

Prior studies establish liquidity as an important consideration in investment decisions. This study examines the existence of the liquidity effects on the nonfinancial common stocks in Stock Exchange of Thailand (SET). Researcher utilizes Fama and French (1993) three-factor model, earning-to-price factor, and Amihud (2002) liquidity proxy to investigate whether the liquidity is priced in Thai stocks or not. This study finds that normal three-factor model works well with large liquid stocks. However, the differences between illiquid and liquid portfolios decrease after adding a liquidity factor to the three-factor model. In the other words, it implies prominence of including a liquidity factor in asset pricing model for SET. The results show that the liquidity-augmented model significantly improves the explanation power on the excess expected stock returns over the three-factor model. Therefore, it suggests that the liquidity-augmented model is a more appropriate choice in explaining Thai stocks returns.

Liquidity, Returns and Investor Heterogeneity in the Corporate Bond Markets

We examine how investor heterogeneity affects the relation between liquidity changes and yield spread changes, using newly-available trade data for more than 3,700 bonds of 635 issuers. We find that, for retail trades, liquidity is a significant determinant of yield spreads and adds substantially to the explanatory power of regressions, after accounting for issuer and market risk. Further, the impact of liquidity is inversely related to retail traders' expected holding period. In contrast, for institutional trades, liquidity and yield spreads are essentially unrelated at all holding periods. We further find, for retail traders, the return premia to holding illiquid bond portfolios is positive and concave in the expected holding period, as predicted by Amihud and Mendelson (1986). Moreover, retail traders earn greater return premia than institutions for the same holding period. Thus, the market at least partially compensates retail investors for the greater illiquidity of their bond trades. Our results point to the importance of investor heterogeneity for understanding the determinants of credit risk.