Illiquidity Shocks Research Articles

Is there a “Flight to liquidity” phenomenon in the Saudi stock market?

The study examines how market illiquidity shocks affect stock prices and explores the "flight to liquidity" phenomenon in the largest stock market in the Middle East, specifically the Saudi stock market. It analyzes the relationship between these shocks and stock prices to understand the impact on both small and large firms. Utilizing a comprehensive database that contains daily data of all stocks listed on the Saudi stock market for over 20 years, the research evaluates the illiquidity of each stock and the entire market on a weekly basis. Market illiquidity shocks are determined using an autoregressive model, and the effect of these shocks on Saudi stock prices is assessed through illiquidity betas in linear regressions for both large and small firms. Initial findings show that illiquidity shocks were significant during periods of oil price declines and global financial crises. The results confirm that stock prices fall in response to market illiquidity shocks, with the impact varying by firm size; larger firms' stocks are less affected, indicating a flight to liquidity towards larger firms during market downturns. This pattern aligns with observations in the US and some emerging markets.

What is the Effect of VIX and (un)Expected Illiquidity on Sectoral Herding in US REITs during (Non)Crises? Evidence from a Markov Switching Model (2014 – 2022)

The study investigates the impact of sector and market-wide illiquidity shocks on herding within US Real Estate Investment Trusts (REITs), on a sub-sector level, including health, hotel, mortgage, residential, retail and Warehouse REITs. Using daily data from January 2014 to February 2022, and consistent with noise trader risk theory, the research confirms the existence of herding behavior within US REITs on a sub-sector level, along with identifying that herding effects are intense on days with negative market returns as compared to days with positive market returns. Assessing the impact of investor sentiments via the VIX index, we find that herding behavior rises with a hike in investor uncertainty and fear. Motivated by the presence of a structural break within our data set corresponding to the Covid-19 outbreak, we use a Markov Switching approach and find significant evidence of sub-sector herding being more intense during the crash regime/covid-19 phase, relative to the expansionary phase. When assessing illiquidity, our results confirm that i) during the expansionary phase only expected illiquidity (market and sector-wide) enhances sub-sector herding within US REITs while ii) during the crash phase only unexpected illiquidity (market and sector-wide) enhances sub-sector herding within US REITs.

Price behavior of small and medium enterprises on the Saudi stock exchange in the face of market illiquidity

This research examines the impact of market illiquidity on asset prices. This topic has been widely discussed in the U.S. market, particularly in relation to the effects on small-caps and large-caps. The objective of this study is to investigate the relationship between returns and market illiquidity shocks on the Saudi stock exchange, with a specific focus on medium and small capitalizations. Small and medium enterprises (SMEs) in Saudi Arabia play a significant role in driving economic growth, comprising 99.5% of the private sector. Given their importance in diversifying the Saudi economy and enhancing non-oil sectors, it is crucial to examine how the stock prices of these enterprises respond to market liquidity issues. To achieve this, illiquidity shocks are estimated for the Saudi stock exchange, followed by an assessment of the overtime relationship between SME returns and the estimated shocks using seven industrial group portfolios. The estimation results validate previous findings and demonstrate that illiquidity shocks in the Saudi market lead to lower prices for all SMEs, irrespective of their industrial group. Moreover, I explore whether this relationship differs between medium and small enterprises. Previous studies have suggested that market illiquidity shocks have a more pronounced impact on the stock prices of small capitalizations compared to large capitalizations. However, my estimation results indicate that the negative effects of illiquidity shocks on stock prices do not significantly differ between medium-sized and small-sized enterprises. This finding is attributed to the lack of substantial disparities in the time-series returns of both portfolio sizes.

A tale of idiosyncratic volatility and illiquidity shocks: Their correlation and effects on stock returns

This paper documents that the idiosyncratic volatility shock is not a stand-alone anomaly compared to the illiquidity shock. Our empirical evidence shows that the illiquidity shock Granger-causes idiosyncratic volatility shock and is statistically and economically significant in predicting stock returns. More importantly, it subsumes most of the predictive power of idiosyncratic volatility shock. In addition, we find that it is the illiquidity shock, not idiosyncratic shock, that is significantly affected by earnings surprise and is more consistently related to other information-signaling variables such as changes in analyst dispersion, number of sell-side analyst coverage, and institutional ownership.

Эффекты неликвидности на российском рынке акций

This work examines the impact of expected and unexpected illiquidity of Russian stockstraded on the Moscow Exchange on their ex ante and simultaneous excess returns. Following quantitative predictions of the market microstructure invariance hypothesis, I calculate the ex­pected ruble costs of executing a bet in the Russian stock market. This estimate is used to compute the invariance-implied low-frequency illiquidity measure for individual stocks. The expec­ted market illiquidity is estimated by a first-order autoregressive model, and the surprise illiquidity is the residuals from this model. We use two weighting methods (equal-weighting and value-wei­ghting) to calculate market returns, market illiquidity, as well as returns on size-based portfolios. According to the empirical analysis over the period from January 2010 to December 2020, the market premium for expected illiquidity in the Russian equity market was insignificant in most specifications, unlike the effect of unexpected market illiquidity. The negative effect of market illiquidity shocks on market returns is insignificant only in the case of using equal-weighted procedure over the period from January 2010 to June 2015. The weak form of the hypothesis that illiquidity effects are stronger for small-cap stocks is confirmed only in the case of using equal-weighting method over the period from July 2015 to December 2020.

The analysis of relationship between financial markets' illiquidity shocks and macroeconomic dynamics: Time-varying parameter vector autoregression (TVP-VAR) approach in Iran

تحقیقات اخیر نشان داده است که نقدشوندگی بازار‌های مالی عمده جهان در طول زمان متفاوت بوده و غیرقابل‌پیش‌بینی بودن نقدشوندگی این بازار‌ها منبع مهمی از ریسک برای سرمایه‌گذاران می‌باشد. این شوک نقدشوندگی بازار‌های مالی بر اقتصاد کلان تأثیرگذار است. در این تحقیق به تحلیل ارتباط شوک‌های عدم نقدشوندگی بازار مالی و پویایی‌های اقتصاد کلان با رویکرد خود رگرسیون برداری با ضرایب متغیر در زمان (TVP-VAR) در ایران پرداخته شده است. نتایج مطالعه با به‌کارگیری داده‌های سری زمانی فصلی طی سال‌های 1387:3 تا 1399:4 نشان می‌دهد که واکنش رشد تولید در دوره‌های مورد مطالعه به شوک عدم ‌نقدشوندگی منفی و کاهشی می‌باشد. همچنین شوک‌های عدم نقدشوندگی دارای اثرگذاری فزاینده بر تورم بوده اثرگذاری رشد حجم نقدینگی به این شوک‌ها نیز در دوره مورد مطالعه با افزایش نسبی همراه بوده است. سرانجام اثرگذاری شوک عدم نقدشوندگی بازار سهام بر نرخ بیکاری در ابتدا دوره‌ و سال‌های مورد بررسی افزایش بوده و در ادامه و انتهای سال‌ها و دوره‌ها این اثر کاهش یافته است.

Tracking market and non-traditional sources of risks in procyclical and countercyclical hedge fund strategies under extreme scenarios: a nonlinear VAR approach

The subprime crisis was quite damaging for hedge funds. Using the local projection method (Jordà 2004, 2005, 2009), we forecast the dynamic responses of the betas of hedge fund strategies to macroeconomic and financial shocks—especially volatility and illiquidity shocks—over the subprime crisis in order to investigate their market timing activities. In a robustness check, using TVAR (Balke 2000), we simulate the reaction of hedge fund strategies’ betas in extreme scenarios allowing moderate and strong adverse shocks. Our results show that the behavior of hedge fund strategies regarding the monitoring of systematic risk is highly nonlinear in extreme scenarios—especially during the subprime crisis. We find that countercyclical strategies have an investment technology which differs from procyclical ones. During crises, the former seek to capture non-traditional risk premia by deliberately increasing their systematic risk while the later focus more on minimizing risk. Our results suggest that the hedge fund strategies’ betas respond more to illiquidity uncertainty than to illiquidity risk during crises. We find that illiquidity and VIX shocks are the major drivers of systemic risk in the hedge fund industry.

Systematic illiquidity, characteristic illiquidity, and stock returns: Timeseries analysis

The objective of this research is to investigate the relationship between illiquidity and stock prices on the Tunisian stock exchange. While previous researches tended to focus on one form of illiquidity to examine this relationship, our study unifies three forms of illiquidity at the same time. Indeed, we simultaneously consider illiquidity as systematic risk, as a characteristic of the market, and as a characteristic of the stock. The aggregate illiquidity of the market is the average of individual stock illiquidity. The illiquidity risk is the sensitivity of the stock price to illiquidity shocks. Shocks of market illiquidity are estimated by the innovations in the expected market illiquidity. Results show that investors on the Tunisian stock exchange do not require higher returns when they expect a rise of market illiquidity, whereas investors on U.S markets are compensated for higher expected market illiquidity. In addition, shocks of market illiquidity provoke a fall in stock prices of small caps, while large caps are not sensitive to market illiquidity shocks. This differs slightly from results based on U.S. data where illiquidity shocks reduce all stock prices but most notably those of small caps. Robustness tests validate our findings. Our results are consistent with previous studies which reported that the “zero-return” ratio predicts significantly the return-illiquidity relationship on emerging markets.

Does portfolio concentration affect performance? Evidence from corporate bond mutual funds

This paper examines the relation between portfolio concentration and investment performance in corporate bond mutual funds. Using detailed holdings data, we construct portfolio concentration measures at the firm, industry, and credit rating levels. We find that portfolio concentration is significantly positively related to expected abnormal returns of corporate bond funds, and this relation is mainly driven by investment-grade funds. High-yield funds, however, do not exhibit such a relation, possibly due to the erosion of the value of portfolio concentration by liquidity costs. In support of this conjecture, we document that the concentration-performance relation is less pronounced among funds with higher sensitivities to market-wide illiquidity innovations and during periods of bond market illiquidity shocks and fund-level net money outflows. Finally, we show that more concentrated funds demonstrate stronger performance persistence, and investors appear to consider portfolio concentration in making investment decisions.

Does Portfolio Concentration Affect Performance? Evidence from Corporate Bond Mutual Funds

This paper examines the relation between portfolio concentration and investment performance in corporate bond mutual funds. Using detailed holdings data, we construct portfolio concentration measures at the firm, industry, and credit rating levels. We find that portfolio concentration is significantly positively related to expected abnormal returns of corporate bond funds, and this relation is mainly driven by investment-grade funds. High-yield funds, however, do not exhibit such a relation, possibly due to the erosion of the value of portofio concentration by liquidity costs. In support of this conjecture, we document that the concentration-performance relation is less pronounced among funds with higher sensitivities to market-wide illiquidity innovations and during periods of bond market illiquidity shocks and fund-level net money outflows. Finally, we show that more concentrated funds demonstrate stronger performance persistence, and investors appear to consider portfolio concentration in making investment decisions.

The response of hedge fund higher moment risk to macroeconomic and illiquidity shocks

Risk related to return higher moments is usually perceived as substantial in the hedge fund industry. In this article, we relate the return co-skewness and co-kurtosis of hedge fund strategies to macroeconomic and financial shocks. We find that hedge funds’ return higher moments are quite sensitive to these shocks, and especially during the subprime crisis. Our robust IV-GMM estimation procedure reveals that output shocks are more important for explaining the co-kurtosis of most hedge fund strategies than shocks related to jumps in the VIX, while we find the opposite for co-skewness. This suggests that hedge funds better monitor their co-kurtosis. Our VAR experiments show that the bulk of the reaction of higher moment risk to shocks occurs during recessions. Furthermore, some directional strategies—like short-sellers and futures—successfully track shocks and deliver higher returns during periods of crisis, benefiting from market volatility analogously to lookback straddles. Our results also suggest that illiquidity factors are subject to endogeneity and may be viewed as indicators of return smoothing, especially during crises. Robustness checks show that the practice of return smoothing may lead to a serious underestimation of hedge fund higher moment systematic risk, and particularly fat-tail risk.

Time‐varying responses of stock returns to market illiquidity: Stress scenario with regime‐switching framework

AbstractWe test the time‐varying stock return responses to both expected and unexpected market illiquidity. Using a Markov‐switching methodology on Tunisian market data, we find that expected and unexpected market illiquidity effects on Tunisian small‐cap returns are always negative and stable. But for large caps, unexpected market illiquidity (illiquidity shock) effect on stock returns varies over time across two distinct regimes. In the first regime, illiquidity shocks have small effect on stock returns, whereas in the second regime, this effect rises threefold compared to its magnitude in first regime. The second regime (stress scenario) is short lived and characterized by high volatility. We also find that effect of expected market illiquidity on large cap returns is insignificant. In addition, we investigate the factors that lead to the stress scenario on stock exchange of Tunis. We find that stress scenario is contingent to funding illiquidity and economic distress in Tunisia. Results prove that Tunisian economic distress occurred in the context of subprime crisis and Tunisian political crisis of 2010.

LİKİDİTE HASSASİYETİNİN BORSA İSTANBUL’DAKİ PAY SENETLERİNİN GETİRİLERİ ÜZERİNE ETKİSİ

This study investigates the equity exposure to liquidity risk factors in Borsa Istanbul between 1992-2015. Stock level cross-sectional regression and univariate portfolio analysis are utilized to examine the predictive ability of liquidity risk in Turkish markets. The widest range of illiquidity proxies are used to test this effect. Cross-sectional regression analyses show that illiquidity betas predict expected equity returns. This relation remains robust when well-known priced factors are controlled for. The univariate portfolio analysis documents that equities that are more sensitive to illiquidity shocks generate 5% higher annualized returns than those that are less sensitive to liquidity shocks. Hence, these findings show that liquidity exposure is indeed priced for equity returns in Borsa Istanbul.

Illiquidity and Stock Returns II: Cross-section and Time-series Effects

Abstract Lou and Shu decompose Amihud’s illiquidity measure (ILLIQ) proposing that its component, the average of inverse dollar trading volume (IDVOL), is sufficient to explain the pricing of illiquidity. Their decomposition misses a component of ILLIQ that is related to illiquidity. We find that this component affects stock returns significantly, both in the cross-section and in time-series. We show that the ILLIQ premium is significantly positive after controlling for mispricing, sentiment, and seasonality. In addition, the aggregate market ILLIQ outperforms market IDVOL in estimating the effect of market illiquidity shocks on realized stock returns.

A Financial Accelerator through Coordination Failure

AbstractThis article studies the effect of liquidity crises in short-term debt markets in a dynamic general equilibrium framework. Creditors (retail banks) receive imperfect signals regarding the profitability of borrowers (wholesale banks) and, based on these signals and their beliefs about other creditors’ actions, choose whether to roll over funding, or not. The unco-ordinated actions of creditors cause a suboptimal incidence of rollover, generating an illiquidity premium. Leverage magnifies this co-ordination inefficiency. Illiquidity shocks in credit markets result in sharp contractions in output. Policy responses are analysed.

Sovereign Credit Rating Announcements and Liquidity Shocks in the Lebanese Daily Foreign Exchange Market

Sovereign credit rating announcements are usually unexpected events that can affect local financial markets either favorably or detrimentally. In Lebanon, the credit outlook witnessed a deteriorating trend since the mid of the year 2016. The major hypothesis of this paper is that the reaction to the bad credit rating announcements is statistically significant, although ephemeral, delimited to just a few days. It is through the liquidity channel that these announcements create uncertainty and affect the economy. There are two related hypotheses: (1) illiquidity shocks impact undesirably the financial markets, and (2) credit rating announcements are accompanied by a surge in illiquidity. Since the impact of these announcements is ephemeral it should be assessed by high-frequency data, or at most by daily financial data. The domestic foreign exchange market is an ideal place to study this impact. Fortunately, the central bank of Lebanon has lately made available daily foreign exchange rates for six major currencies beginning in 2010. This defines six multiple regressions that are constructed to differentiate between the short-run and the long-run responses to illiquidity. The empirical results show that the above two hypotheses are strongly supported. Moreover, it matters little whether the event window is 3, 4 or 5 days.
 JEL Classification: G14, F31, C58, C38.

UNDERSTANDING THE MACROECONOMIC IMPACT OF ILLIQUIDITY SHOCKS IN THE UNITED STATES

In this paper, we empirically investigate the role of stock market illiquidity shocks, stemming from Amihud's illiquidity measure, in explaining U.S. macroeconomic fluctuations from 1973 to 2018. We find that the impact of illiquidity shocks on economic activity is substantial, and historical decomposition analysis shows that cumulative illiquidity shocks were an essential contributor to the prolonged economic slump of the Great Recession. Moreover, our identified illiquidity shocks represent a distinct source of macroeconomic instability. This suggests that illiquidity shocks, measured by the stock price impacts, may contain more information than other types of shocks in recent studies, such as financial shocks and uncertainty shocks. (JEL C32, E32)

The Term Structure of Liquidity Premium

We analyze the term structure of Treasury liquidity premium (LP). Through a model where illiquidity shocks are alleviated by holding Treasuries, we show that LP term structure is shaped by expectations of future market liquidity, liquidity term premium, and Treasury supply. As predicted, the LP term structure is downward-sloping in recessions but upward-sloping in booms, and forward LP predicts future LP and market liquidity. Furthermore, LP is quantitatively important for monetary policy pass-through: LP dampens the pass-through of interest rate policy yet strengthens the pass-through of quantitative easings. We also use LP to infer the term structure of Treasury safety premium.

Real Estate Illiquidity and Returns

This paper proposes two new measures of illiquidity for real estate markets utilising concepts from asset pricing. Segregating real estate through a regional lens, we provide an in-depth analysis of real estate returns and illiquidity for the US and UK using time-varying parameter VAR models. Density forecasts show real estate illiquidity holds prominent predictive power for returns over and above a variety of control variables. Our models reveal that illiquidity shocks significantly depress returns and are economically meaningful explaining up to 28\% of regional return variation. Network analysis uncovers substantial heterogeneities in the influence of illiquidity shocks over time with the implication that real estate investors may be able to diversify away, or hedge against, regional spillover exposure.

Pricing of time-varying illiquidity within the Eurozone: Evidence using a Markov switching liquidity-adjusted capital asset pricing model

This paper investigates time-varying characteristics of illiquidity and the pricing of its risk using a liquidity-adjusted capital asset pricing model (L-CAPM). Collecting data from a pool of Eurozone countries between 1990 and 2018, we employ Markov switching models to assess the degree of persistence of illiquidity shocks. Contrary to prior research, which largely makes use of autoregressive (AR) processes, we provide strong evidence that illiquidity is time-varying and the persistence of shocks determines two distinct regimes characterised by high and low illiquidity. We assess pricing of illiquidity risk by developing and empirically testing a conditional L-CAPM model, where different regimes constitute priced risk factors for the cross-section of stock returns. We extend previous unconditional versions of L-CAPM models and we show that the various channels through which illiquidity affects asset returns and price of risks are time-varying. We find strong support for our conditional L-CAPM and our results are robust to alternative specifications and estimation techniques. These findings have important implications for portfolio management practices and are relevant to portfolio and risk managers and regulatory institutions.