Illiquidity Level Research Articles

Asset pricing with extreme liquidity risk

Abstract Defining extreme liquidity as the tail of the illiquidity for all stocks, I propose a direct measure of market-wide extreme liquidity risk and find that it is priced cross-sectionally in the U.S. Between 1973 and 2014, the stocks with high extreme liquidity risk beta earned value-weighted average return of 5.88% annually higher than the stocks with low extreme liquidity risk beta, adjusted for the illiquidity level premium and exposures to aggregate liquidity risk as well as the market, size and value factors. The extreme liquidity risk premium is different from that on aggregate liquidity risk documented in Pastor and Stambaugh (2003) as well as that based on the tail risk in return of Kelly and Jiang (2014). Extreme liquidity risk provides an advance warning about extreme liquidity events. I explore potential economic mechanisms through which the rare and large fluctuations in stock-level liquidity are priced.

Empirical tests on the asset pricing model with liquidity risk: An unobserved components approach

The aim of this paper is to test empirically the conditional liquidity-adjusted capital asset pricing model (L-CAPM) developed by Acharya and Pedersen (2005). Accordingly, we propose to estimate the L-CAPM using unobserved components methodology, which allows us to take into account the main stylized facts characterizing liquidity. Based on a sample of firms listed on the NASDAQ, our empirical analysis reveals several findings. Firstly, we show that liquidity is time-varying and exhibits strong seasonality. Secondly, we highlight the impact of the liquidity level premium on asset prices. Thirdly, we show that the most important liquidity risk is related to the covariance between portfolio illiquidity and market returns. Fourthly, we observe a negative relationship between portfolio returns and market illiquidity. Fifthly, we find that liquidity risk and illiquidity level are not always positively correlated.

Liquidity and the implied cost of equity capital

We investigate the impact of liquidity level and risks on the implied cost of equity capital for 14,808 stocks from 52 countries. We find that the implied cost of equity increases in the illiquidity level and in the co-variance between firm-level illiquidity and market illiquidity, but decreases both in the covariance between firm-level returns and market illiquidity and in the co-variance between firm-level illiquidity and market returns. Specifically, an increase from the 25th to the 75th percentile of the aggregate liquidity risk factor increases the cost of equity by 109 basis points. The evidence we report is robust to wide range of tests. We also observe that liquidity level and risks impact the implied cost of equity during crisis and no-crisis periods, but this relation is more pronounced during crisis periods for the most illiquid stocks.

Stock Liquidity Risk and the Cross-Sectional Earnings-Returns Relation

We argue that a higher sensitivity to aggregate market-wide liquidity shocks (i.e. a higher liquidity risk) implies a tendency for a stock’s price to converge to fundamentals. We test this intuition within the framework of the earnings-returns relation. We find a positive liquidity risk effect on the relation between return and expected change in earnings. This effect on the earnings-returns relation is distinct from the negative effect observed for stock illiquidity level. Notably, the liquidity risk effect is evident (absent) during periods of neutral/low (high) aggregate market liquidity. We also show that the liquidity risk effect is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book-to-market; and (c) are profit making.

Stock Liquidity Risk and the Cross‐sectional Earnings‐Returns Relationship

AbstractWe argue that a higher sensitivity to aggregate market‐wide liquidity shocks (i.e., a higher liquidity risk) implies a tendency for a stock's price to converge to fundamentals. We test this intuition within the framework of the earnings‐returns relationship. We find a positive liquidity risk effect on the relationship between return and expected change in earnings. This effect on the earnings‐returns relationship is distinct from the negative effect observed for stock illiquidity level. Notably, the liquidity risk effect is evident (absent) during periods of neutral/low (high) aggregate market liquidity. We also show that the liquidity risk effect is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book‐to‐market; and (c) are profit making.

Does illiquidity matter in residential properties?

ABSTRACTNo, it does not, despite the general perception that illiquidity matters in real estate. As expected, our evidence shows that the illiquidity costs for the U.S. residential properties are large. The costs are equivalent to 12% of the total property returns on average, ranging from 9.5% to 29.5% of property prices depending on the illiquidity level and market conditions. However, when amortized by holding periods, monthly illiquidity costs are on average 0.08%, and illiquidity risk does not appear to be priced in residential properties; illiquid properties do not show higher returns than liquid properties. On the contrary, we find evidence of flight-to-quality in bull markets, that is, high-quality illiquid properties are preferred to low-quality liquid properties in buoyant markets. These results are in sharp contrast with those in equities and bonds where flight-to-liquidity has been reported when markets are in stress.

Equilibrium Asset Pricing with Both Liquid and Illiquid Markets

I study a general equilibrium model in which investors face endowment risk and trade two correlated assets; one asset is traded on a liquid market whereas the other is traded on an illiquid over-the-counter (OTC) market. Endowment shocks not only make prices drop, they also make the OTC asset more difficult to sell, creating an endogenous liquidity risk. This liquidity risk increases the risk premium of both the OTC asset and liquid asset. Furthermore, the OTC market frictions increase the trading volume and the cross-sectional dispersion of ownership in the liquid market. Finally, if the economy starts with only the OTC market, then I explain how opening a correlated liquid market can increase or decrease the OTC price depending on the illiquidity level. The model's predictions can help explain several empirical findings.

Extreme Liquidity Risk, Its Premium from Market Downturns, and the Cross-Section of Stock Returns

I construct a measure of the extreme liquidity risk factor based on the contraction and expansion of monthly cross-sectional distributions of individual illiquidity measures and investigate its asset pricing implications. I find strong empirical evidence (1) that the extreme liquidity risk is priced in the cross-section of expected stock returns and (2) that its premium comes only from market-downturn loadings. The extreme liquidity risk commands an annual premium of 3.3% for one standard deviation increase in its market-downturn loading. The main findings still hold after controlling for known factor loadings, including the loadings of liquidity risk factor and return tail risk factor, as well as various rm characteristics, including size, book-to-market, momentum, Amihud illiquidity level, and extreme Amihud illiquidity level. The cross-sectional pricing evidence of the extreme liquidity risk survives (1) time-varying factor loadings, (2) extended test portfolios augmented by 30 Fama-French industry portfolios, and (3) diagnostic tests for a useless factor.

Empirical Test of the Liquidity-Based Theory of the Closed-End Funds

Theory argues that the rationale for the existence of closed-end funds (CEFs) is that they provide investors indirect exposure to their underlying illiquid assets without the high cost associated with trading them directly. Consistent with this reasoning, we show that risk-averse investors invest in CEFs to diversify their portfolios into the illiquid markets in which CEFs specialize. Moreover, investor demand for CEFs is a positive function of the CEF portfolio’s illiquidity level. A direct comparison of CEF holdings with those of CEF investors reveals that the latter underweight stocks invested by CEFs, which are typically small and illiquid. Such impacts of liquidity on investment behavior also vary across investor identities, depending on the level of fiduciary responsibility, investment horizon, and investment style. Beyond the CEF industry, our findings shed new insights on the benefits of the closed-end structure observed in other market segments.

Does Commonality in Illiquidity Matter to Investors?

This paper investigates whether investors are compensated for taking on commonality risk in equity portfolios. A large literature documents the existence and the causes of commonality in illiquidity, but the implications for investors are less understood. We find a return premium for commonality risk in NYSE stocks that is both economically and statistically significant. The commonality risk premium is independent of illiquidity level effects, and robust to variations in illiquidity measurement and systematic illiquidity estimation. We also show that precision in commonality risk estimation can be increased by the use of daily illiquidity measures, instead of monthly.

Liquidity and expected returns—Evidence from 1926–2008

This paper re-examines the liquidity effect on stock expected returns in the NYSE over the period 1926–2008, the pre-1963 period, for which there is a lack of research, and the post-1963 period. The results from the entire sample of 1926–2008 show that expected returns increase with the stock level illiquidity. However, illiquidity level has explanatory power in the cross-sectional variation of stock expected returns only over the post-1963 period, and is, both economically and statistically, insignificant for the whole sample and the pre-1963 period. These findings are robust after taking into account various characteristics such as size and risk controls. On the other hand, evidence from the entire sample and the pre-1963 sample suggests that the systematic liquidity risk plays a significant role in the cross-sectional variation of stock expected returns. The different result for the pre- and post-1963 is explained by the portfolio shifts occurred during the economic downturns.

The components of the illiquidity premium: An empirical analysis of US stocks 1927–2010

This paper implements a conditional version of the liquidity adjusted CAPM (LCAPM). The conditional LCAPM allows for a time-varying decomposition of the total illiquidity premium into a level component and three risk components. The estimated average annual total illiquidity premium for US stocks 1927–2010 is 1.74–2.08%, which is substantially lower than in most previous studies. The contributions from illiquidity level and illiquidity risk are 1.25–1.28% and 0.46–0.83%, respectively. Of the three illiquidity risk components, risk related to the hedging of wealth shocks is the most important, while commonality risk is the least important. The illiquidity premia are clearly time-varying, with peaks in downturns and crises, but with no general tendency to decrease over time. The level premium and the risk premium are significantly positively correlated, at around 0.35; indicating that in periods of turbulence both illiquidity cost and illiquidity risk premia tend to be high.

Liquidity Risk and Cross-Sectional Earnings-Returns Relation

Employing a broad sample of US firms over the period 1962 to 2009, we provide evidence of a liquidity risk impact on the fundamental earnings-returns relation. Specifically, we document that current liquidity risk has a positive moderating effect on the relation between current returns and next period change in earnings. Notably, this effect is distinct from (and after controlling for) the negative effect observed for illiquidity level (Kerr, Sadka and Sadka, 2012). We further show that the liquidity risk effect on the earnings-returns relation is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book-to-market; and (c) are profitable.

Liquidity Measures, Liquidity Drivers and Expected Returns on an Early Call Auction Market

We analyze the determinants of illiquidity and its impact on asset pricing for purely call auction traded stocks on Berlin Stock Exchange using 22 years of daily data (1892-1913). We use the Lesmond et al. (1999) measure of transaction costs to proxy illiquidity. We show that transaction costs were low and comparable to today’s costs. Liquidity was negatively correlated with active informed trading, particularly being low for small and distressed stocks and in crises times. Liquidity concerns were a major driver of asset pricing: we find significant illiquidity level and illiquidity risk premia as well as an explicit premium for informed trading.

The Components of the Illiquidity Premium: An Empirical Analysis of U.S. Stocks 1927-2010

This paper estimates a conditional version of the liquidity adjusted CAPM by Acharya and Pedersen (2005) using NYSE and AMEX data from 1927 to 2010 to study the illiquidity premium and its variation over time. The components of the illiquidity premium is in this model derived as the level of expected illiquidity together with three types of illiquidity risks. We measure illiquidity of individual stocks by the efficient spread proxy developed in Holden (2009) and employ illiquidity sorted portfolios as test assets. The average annual illiquidity premium is estimated to 1.55%, the respective contributions from illiquidity level being 1.15% and from the three different illiquidity risks 0.40%. Results also indicate that commonality risk is the least important component in the illiquidity risk premium, while a component related to the hedging of wealth shocks is the most important. The illiquidity premium varies substantially over time, with peaks in downturns and crises, but with no general tendency to decrease over time.

Forestry as a sustainable asset class for turbulent times?

There is good reason to anticipate increased demand for sustainable and responsible investments from both retail and large institutional investors. Increasing interest in forestry may come from both a financial and general sustainability standpoint, and from a carbon perspective, because trees are a critical part of any successful climate change strategy. We develop the true sustainable financial return (TSFR) concept for forestry investment screening which provides a good indication of long-run, sustainable return levels without leverage. Depending on investment horizon and illiquidity level, forestry investments tied to biological growth drivers seem the most attractive. Forestry then qualifies as a sustainable and responsible investment even during periods of financial crisis. In addition, we provide evidence that forestry investments can offer significant value to investors by adding a low correlation with other assets. Ultimately, the business model is proven and successful.