Illiquidity Measure Research Articles

Explaining and Benchmarking Corporate Bond Returns

We evaluate how different betas and characteristics related to default, term, and liquidity risk fare against one another in explaining the cross-section of corporate bond returns. We find that characteristics – credit rating, duration, and Amihud illiquidity measure–fare better. Yields add incremental explanatory power. Consistent with yields providing a timelier assessment of default risk than ratings, bonds with higher yields but similar credit ratings, durations and Amihud measures experience more subsequent ratings downgrades, fewer upgrades, and a higher frequency of defaults. Based on our findings, we present characteristic portfolios that can be used to benchmark individual bond and portfolio returns.

Illusory Nature of Pricing of Illiquidity Risk: The Test Case of Australian Stock Market

Positive illiquidity premium is documented to be linked with the illiquidity effect across global markets. This evidence is generally suggested through some asset pricing model, such as Acharya and Pedersen (2005) or others. Our study shows that the success of any such model in terms of magnitude of predicted risk premium is linked with a measure of illiquidity used in the study. The main implication of this evidence is that the variety of illiquidity related risk premiums can be reported for the same market, or for the number of markets. To elaborate this point, the test case of Australian stock market is taken and likely strategy to determine the maximum illiquidity premium is proposed.

Does short selling improve stock price efficiency and liquidity? Evidence from a natural experiment in China

ABSTRACTChina introduced short selling for designated stocks in March 2010. Using this important policy change as a natural experiment, we examine the effect of short selling on stock price efficiency and liquidity. We show that the introduction of short selling significantly improves price efficiency, as measured by the differences in individual stock responses to market returns and the delay in price adjustments. Short selling also enhances stock liquidity, as measured by bid-ask spread and Amihud [2002. ‘Illiquidity and Stock Returns: Cross-section and Time-series Effects.’ Journal of Financial Markets 5: 31–56] illiquidity measure; and reduces stock volatility. Overall, our results suggest that short selling helps to stabilize asset prices, provides additional liquidity and improves market quality, even in an emerging economy with a less developed stock market than that in the US and Europe.

Social Screens and Systematic Investor Boycott Risk

We model the pricing implications of screens adopted by socially responsible investors. The model reproduces the empirically observed abnormal return to sin stock and implies a premium for systematic investor boycott risk that affects targeted as well as nontargeted firms. The investor boycott premium is not displaced by litigation risk, measures of neglect effect, illiquidity, industry momentum, or concentration. The investor boycott risk factor is useful in explaining mean returns across industries, and its premium varies with the relative wealth of socially responsible investors and the business cycle.

An Application of a Conditional Illiquidity Measure for U.S. Corporate Bond Yields

An Application of a Conditional Illiquidity Measure for U.S. Corporate Bond Yields

Market Illiquidity and Conditional Equity Premium

We examine the time-series relation between aggregate bid-ask spreads and conditional equity premium. We document that average marketwide relative effective bid-ask spreads forecast aggregate market returns only when controlling for average idiosyncratic variance. This control allows us to document the otherwise elusive relation between illiquidity and returns. The reason is that idiosyncratic variance correlates positively with spreads but has a negative effect on conditional equity premium, causing an omitted variable bias. Our results are robust to standard return predictors, alternative illiquidity measures, and out-of-sample tests. These findings are important because they provide strong support for the literature's conjecture that marketwide liquidity is an important asset pricing risk factor.

Identifying Key Drivers of Return Reversal with Dynamical Bayesian Factor Graph.

In the stock market, return reversal occurs when investors sell overbought stocks and buy oversold stocks, reversing the stocks’ price trends. In this paper, we develop a new method to identify key drivers of return reversal by incorporating a comprehensive set of factors derived from different economic theories into one unified dynamical Bayesian factor graph. We then use the model to depict factor relationships and their dynamics, from which we make some interesting discoveries about the mechanism behind return reversals. Through extensive experiments on the US stock market, we conclude that among the various factors, the liquidity factors consistently emerge as key drivers of return reversal, which is in support of the theory of liquidity effect. Specifically, we find that stocks with high turnover rates or high Amihud illiquidity measures have a greater probability of experiencing return reversals. Apart from the consistent drivers, we find other drivers of return reversal that generally change from year to year, and they serve as important characteristics for evaluating the trends of stock returns. Besides, we also identify some seldom discussed yet enlightening inter-factor relationships, one of which shows that stocks in Finance and Insurance industry are more likely to have high Amihud illiquidity measures in comparison with those in other industries. These conclusions are robust for return reversals under different thresholds.

Liquidity and equity returns in Borsa Istanbul

ABSTRACTWe investigate the relationship between expected returns and liquidity measures in Borsa Istanbul. To do so, we gather a wide range of illiquidity measures that can be applied to the market. Firm-level cross-sectional regressions indicate that there is a positive relationship between various illiquidity measures and one- to six-month ahead stock returns. Findings of the article are robust after using different sample periods and controlling for well-known priced factors, such as market beta, size, book-to-market ratio and momentum. The portfolio analysis reveals that stocks that are in the highest illiquidity quintile earn 7.2%–19.2% higher risk-adjusted annual returns than those in the lowest illiquidity quintile. The illiquidity premium is stronger for small stocks and stocks with higher return volatility and it increases (decreases) during periods of extremely low (high) market returns.

Illiquidity premium and expected stock returns in the UK: A new approach

This study examines the relative importance of liquidity risk for the time-series and cross-section of stock returns in the UK. We propose a simple way to capture the multidimensionality of illiquidity. Our analysis indicates that existing illiquidity measures have considerable asset specific components, which justifies our new approach. Further, we use an alternative test of the Amihud (2002) measure and parametric and non-parametric methods to investigate whether liquidity risk is priced in the UK. We find that the inclusion of the illiquidity factor in the capital asset pricing model plays a significant role in explaining the cross-sectional variation in stock returns, in particular with the Fama–French three-factor model. Further, using Hansen–Jagannathan non-parametric bounds, we find that the illiquidity-augmented capital asset pricing models yield a small distance error, other non-liquidity based models fail to yield economically plausible distance values. Our findings have important implications for managing the liquidity risk of equity portfolios.

An index-based measure of liquidity

The liquidity shocks of ’08–’09 revealed that measures of liquidity risk being used in most financial institutions turned out to be woefully inadequate. The construction of long-short portfolios based on liquidity proxies introduces errors such as extraneous risk factors and hedging error. We develop a new measure for liquidity risk using exchange-traded funds (ETFs) that attempts to minimize this error. We form a theoretically-supported measure that is long ETFs and short the underlying components of that ETF, i.e., long and short a similar set of underlying securities with the same weights. Pricing discrepancies between the long and short positions are driven by liquidity differences between the ETF and its underlying components. Constructing liquidity risk factors in a number of markets, we undertake several tests to validate our new liquidity metric. The results show that our illiquidity measure is strongly related to other measures of illiquidity, explains bond index returns, and reveals a systematic illiquidity component across fixed-income markets.

Liquidity, liquidity risk and stock returns: evidence from Vietnam

The question of whether liquidity is priced is a subject for a huge volume of papers in the asset-pricing literature. Asset-pricing theory suggests a negative relationship between these two variables as investors demand higher returns to compensate for less liquid stocks. However, the empirical evidence is not unanimous. This paper investigates the relationship between liquidity and stock return in Vietnam by employing an updated dataset of market and financial data of listed companies in the Ho Chi Minh City stock exchange ranging from 2007 to 2012. Our results suggest that the relationship between liquidity and stock returns is different in Vietnam stock market. In other words, we document a reliable positive relationship between liquidity measures and stock returns and negative relationship between illiquidity measures and stock returns. However, we do not find evidence in supporting the relation between risk associated with fluctuation in liquidity and stock returns.

An Alternative Measure of Illiquidity: Insights on the U.S. Treasury Bills, Notes and Bonds

An Alternative Measure of Illiquidity: Insights on the U.S. Treasury Bills, Notes and Bonds

Rumors and Runs in Opaque Markets: Evidence from Panic of 1907

Using a new daily dataset for all stocks traded on the New York Stock Exchange from 1905 to 1910, we provide the first in-depth, microstructure analysis of the Panic of 1907 - one of the most severe financial crises of the 20th century - and quantify the critical role of asymmetric information in the generation of panic conditions. We first show that quoted equity bid-ask spreads rose six-fold, from 0.5% to 3%, during the peak weeks of the crisis. We then implement a spread decomposition procedure and pinpoint the source of the illiquidity spike in the adverse selection component; that is, the fear of informed trading. Moreover, we show that information costs rose most steeply in the mining sector - the origin of the panic rumors - and in other sectors with opaque corporate reporting standards. In addition to wider spreads and tight money markets, we find other hallmarks of information-based liquidity freezes: trading volume dropped and price impact rose. Importantly, despite shortterm cash infusions into the market, and abatement of the run, we find that the market remained relatively illiquid for several months following the panic. We go on to show that rising illiquidity enters positively in the cross section of stock returns. Thus, our findings demonstrate how opaque markets can easily transmit an idiosyncratic rumor into a long-lasting, market-wide crisis. Our results also demonstrate the usefulness of illiquidity measures to alert market participants to impending market runs.

Stock Illiquidity, Option Prices, and Option Returns

We provide evidence of a strong effect of the underlying stock’s illiquidity on option prices by showing that the average absolute difference between historical and implied volatility increases with stock illiquidity. This pattern translates into significant excess returns of option trading strategies that are not explained by common risk factors. Simulation results show, however, that our results can be explained by the hedging costs of market makers who are sometimes net long and sometimes net short in options. Our empirical findings are robust with respect to the chosen illiquidity measure, the measure of option expensiveness, and the return period.

An Alternative Measure of Illiquidity: Insights on the U.S. Treasury Bills, Notes and Bonds

The paper proposes an alternative measure of illiquidity based on the dynamics of the j-th order conditional serial covariance, relaxing the hypothesis of market efficiency. The empirical findings of the analysis are many: (i) A conditional metrics of illiquidity for short and long term U.S. government debt obligations, its level of skewness and kurtosis are discussed; (ii) The illiquidity of the U.S. treasuries is mainly related to the U.S. stock market illiquidity, the difference of illiquidity between Aaa and Baa U.S. corporate bonds, the spread between the U.S. corporate bond yields, as well as the illiquidity for the 5 Fama-French factors; (iii) The level of the CBOE Volatility Index is statistically significant for explaining the illiquidity premium for the term structure of the U.S. government debt obligations. (iv) The evidence of flight-to-liquidity, from the U.S. equity market to the U.S. treasuries as well as corporate bonds, is discussed during the recent financial turmoil.

Information Asymmetry and Quarterly Disclosure Decisions by Firms: Evidence From the Tokyo Stock Exchange

AbstractThis study investigates whether the new quarterly disclosure reporting requirement issued by the Tokyo Stock Exchange was related to the reduction of the degree of private information‐based trade and the liquidity of listed stocks in Japan, or as a reverse causality, helped dichotomize good firms and bad firms as a separating signaling equilibrium. We use the probability of asymmetric information‐based trade (Adjusted PIN) as a measure of information asymmetry and the probability of symmetric order‐flow shock (PSOS) as a measure of market illiquidity. We use a sample of public firms from 2002 to 2007 that chose to either disclose or not disclose quarterly financial reports. We find that the disclosing firms had lower information asymmetry (Adjusted PIN), lower symmetric order‐flow shocks (PSOS), and lower private information‐based trade (PIN). When we conduct further difference‐in‐differences tests, we find that the firms with lower information asymmetry and higher liquidity had a higher tendency to disclose their financial statements and vice versa. Thus, the new disclosure requirement did not necessarily improve the information asymmetry and liquidity of firms, but instead helped good and bad firms form a case for a separating signaling equilibrium.

Liquidity and conditional market returns: Evidence from German exchange traded funds

In the spirit of Merton (1973), we assert that temporary aggregate market illiquidity is compensated for in the form of higher conditional market returns. In order to test this hypothesis, we use two available liquidity proxies, namely versions of the Amihud illiquidity measure and a measure based on exchange traded fund prices. Our investigation is based on vector autoregressive models for the German stock market between July 2006 and June 2010. The fund-based illiquidity proxy dominates in capturing consistent results for the determination of time-varying market returns. Temporary illiquidity is indeed compensated for by higher market returns. We confirm a bidirectional relation between illiquidity and market returns, i.e. current returns depend on lagged illiquidity and current illiquidity can be determined by a combination of past returns as well as past illiquidity. The relation shows that illiquidity is persistent and driven by market declines.

The Impact of Hedge Funds on Asset Markets

While there has been enormous interest in hedge funds from academics, prospective and current investors, and policymakers, rigorous empirical evidence of their impact on asset markets has been di¢ cult to …nd. We construct a simple measure of the aggregate illiquidity of hedge fund portfolios, and show that it has strong in- and out-of-sample forecasting power for 72 portfolios of international equities, corporate bonds, and currencies over the 1994 to 2011 period. The forecasting ability of hedge fund illiquidity for asset returns is in most cases greater than, and provides independent information relative to, well-known predictive variables for each of these asset classes. We construct a simple equilibrium model to rationalize our …ndings, and empirically verify auxiliary predictions of the model.

Illusory Nature of Pricing of Illiquidity Risk: The Test Case of Australian Stock Market

Positive illiquidity premium is documented to be linked with level and risk of illiquidity effect across global markets. Our study shows that this evidence is subject to variation from one measure of illiquidity to another with one potential implication. That the magnitude of illiquidity premium across global markets is less in previous studies, mainly because only one measure of illiquidity is implied. To elaborate this point the test case of Australian stock market is taken and likely strategy to determine the maximum illiquidity premium across the international markets is proposed. Further it is shown that stock based asset pricing tests are more appropriate to segregate level and risk of illiquidity effect.

Funding Liquidity Implied by S&P 500 Derivatives

We derive a funding illiquidity measure based on synthetic borrowing in the S&P 500 derivative markets. Our measure captures funding constraints of option liquidity providers and affects importantly the returns of leveraged managed portfolios. Hedge funds with negative exposure to changes in the funding illiquidity earn high returns in normal times and low returns in crises periods when funding liquidity deteriorates. The results are not driven by the existing measures of funding or market illiquidity. To an extent, our funding illiquidity measure also affects leveraged closed-end mutual funds and asset classes where leveraged investors are marginal investors.