Liquidity Co-movements Research Articles

Tick Size and Commonality in Liquidity

This study suggests that the change of tick size, particularly in a step-function tick system, accounts for cross-sectional variation in market liquidity. We explored the relative significance of commonality in liquidity in a limit order book during the period of tick-size conversion, and empirically examined the interactions of inventory risk and asymmetric information on liquidity co-movements. We observed that market-wide and within-industry commonality in liquidity is ubiquitous before and after tick-size conversion. Moreover, the small spreads and thin limit order book introduced by the narrowed minimum price variation further strengthened liquidity co-movements. We also observed that trade size and trading frequency exhibited significantly negative influences on spread measures before and after tick-size conversion, whereas significantly positive effects persisted for depth constructs. Finally, we documented affluent industry-wide liquidity co-movements before and after tick-size conversion, after accounting for marginal influences of potent idiosyncratic liquidity determinants including volatility, market price, and trade volume. Our empirical evidence reveals that a narrow tick size might generate considerable market-wide liquidity risk and produce adverse effects on market quality.

Transaction Costs and Liquidity Co-Movements within and Across Exchanges: Evidence from Vietnam

Employing a sample of all domestic stocks listed on the two Vietnamese stock exchanges – Hochiminh Stock Exchange (HOSE) and Hanoi Stock Exchange (HNX) over the 2007-2014 period, we find that the transaction costs for HOSE-listed stocks are about half of those for HNX-listed stocks. This difference persists over the sample period, across most industries, and is smaller with size. We also provide evidence of both within and cross-exchange liquidity co-movements in both Vietnamese stock exchanges. However, we do not find that co-movements in liquidity are stronger in HOSE than HNX, and vice versa. Our findings are important to many parties including exchange regulators, and domestic and international investors in Vietnam.

Systematic Liquidity and Leverage

Does trader leverage exacerbate the liquidity co-movement that we observe during crises? We exploit the threshold rules governing margin trading eligibility in India to identify a causal relationship between trader leverage and the extent to which a stock’s liquidity covaries with the liquidity of other stocks. We find that trader leverage causes sharp increases in comovement during severe market downturns. For our sample of stocks, the estimates suggest that the trader leverage channel explains about one third of the increase in liquidity commonality that we observe during crises. Consistent with downward price pressure due to the deleveraging of traders who rely on borrowing, we also find that leverage causes stocks to exhibit large increases in return comovement during crises.

High Frequency Trading and Co-Movement in Financial Markets

Using the staggered entry of Chi-X in 12 European equity markets as a source of exogenous variation in high frequency trading (HFT), we find that HFT causes significant increases in co-movement in returns and in liquidity. About one-third of the increase in return co-movement is due to faster diffusion of market-wide information. We attribute the remaining two-thirds to correlated trading strategies of HFTs. The increase in liquidity co-movement is consistent with HFT liquidity providers being better able to monitor other stocks and adjust their liquidity provision accordingly. Our findings suggest a channel by which HFT impacts the cost of capital.

Commonality in Liquidity: The Impact of Financial Crisis and Regulation NMS

Following the liquidity dry-ups witnessed during the 2007-09 financial crisis, many studies highlighted the relation between market downturns and increased co-movements in liquidity. This study examines whether the mid-2007 implementation of Regulation National Market System (Reg NMS) played a contributing role in driving equity liquidity co-movements, and whether its impact has been confounded with that of the recent crisis. Results from a dynamic factor model approach confirm the recent crisis's impact on increasing co-movements within bid-ask spreads, and additionally demonstrate that Reg NMS contributed to structural changes in commonality within dollar volumes even prior to the crisis.

Commonality in Liquidity: A Demand-Side Explanation

We hypothesize that a source of commonality in a stock's liquidity arises from correlated trading among the stock's investors. In support of this hypothesis, we find that stocks with high mutual fund ownership have comovements in liquidity that are about twice as large as those for stocks with low mutual fund ownership. We also find that stocks owned by mutual funds with higher turnover and those owned by mutual funds that experience liquidity shocks themselves have higher commonality in liquidity. These results suggest an important role for the demand side of liquidity in explaining commonality.

Commonality in Liquidity: A Demand-Side Explanation

We hypothesize that a source of commonality in a stock’s liquidity arises from correlated liquidity demand of the stock’s investors. Focusing on correlated trading of mutual funds, we find that stocks with high mutual fund ownership have comovements in liquidity about twice as large as those for stocks with low mutual fund ownership. Further analysis shows that the channels for these comovements derive from both common ownership across funds and funds’ correlated liquidity shocks. We obtain inferences supporting causality from an exogenous flow shock for mutual funds in the aftermath of the 2003 mutual fund scandal.

Commonality in News Around the World

Motivated by the pioneering study of Morck, Yeung, and Yu (2000), this paper investigates whether and how news commonality varies according to a country’s institutional environments. Using a unique global news data set across 41 countries for the 2000-2009 period, we document three notable findings. First, firm-level news comoves more in countries with weaker institutional environments than in those with stronger institutional environments. Second, news commonality is positively associated with both stock return comovement and stock liquidity commonality. Third, the effect of news commonality on stock return and liquidity comovement is higher in countries with stronger institutions than in those with weaker institutions. These results suggest that a country’s institutional environments affect firm-specific information production and, more importantly, support the information-efficiency view that lower price synchronicity is caused by greater capitalization of firm-specific information.

Commonality in liquidity in emerging markets: Another supply-side explanation

Emerging markets share many distinct features that separate them from more developed markets, including low liquidity and high commonality in liquidity. This study on 18 emerging markets finds that individual stock liquidity is more affected by systematic volatility than by idiosyncratic volatility, suggesting that higher commonality in liquidity in emerging markets could be caused by higher co-variation in stock volatility and co-variation in inventory risk. Consistent with this conjecture, commonality in liquidity is found to be positively related to co-movement in volatility, and negatively related to the level of development of the financial markets. This study also documents that liquidity co-movement across emerging markets has a strong geographic component and is related to a correlation in market-wide volatility. The results do not support the presence of a global liquidity factor, and suggest that liquidity risk can be diversified by constructing global portfolios.

On the intensity of liquidity spillovers in the Eurozone

This paper seeks to elucidate dimensions and directions of the liquidity spillover phenomenon in the Eurozone equity markets during the global financial crisis of 2007–2008. The research examines questions relevant to the shift-contagion in the Eurozone countries during the time of crisis, as well as the role of a liquidity channel of transmission relaying external shocks among those countries. The findings document the existence of non-linearities in the transmission mechanisms across selected markets; we use a structural model introduced by Favero and Giavazzi (2002) while controlling for interdependence. The result is in line with the crisis-contingent theories that suggest transmission of shocks through an endogenous liquidity channel. Furthermore, we notice a pattern of liquidity spillover from small markets to the German, French, Italian and UK markets even after controlling for monetary policy shocks, and we confirm the persistence of liquidity co-movements, supporting the argument that financial contagion in the Eurozone market was transmitted and intensified via the liquidity channel.

A Multi-Factor Measure for Cross-Market Liquidity Commonality

Liquidity commonality is defined as liquidity co-movements across assets or markets. In the current literature, it is measured relative to a single factor, i.e., the average liquidity across assets or markets. However liquidity co-movements may not be fully captured by this single factor. Other factors, e.g., aggregate return and volatility, may also contribute to liquidity comovements. Using Asian stock markets as an example, this paper reports that following findings: (1) From January 2000 to April 2010, cross-market liquidity commonality accounts over 9% of daily liquidity variations for Asian emerging markets, and around 14% for Asian developed markets. These numbers are considerably higher than the 1% to 2% reported in previous studies based on cross-asset liquidity commonality. (2) Regional factors affect liquidity commonality through shocks in liquidity and volatility, while global factors affect liquidity commonality through return and volatility. (3) Cross-market liquidity commonality has increased significantly during and after the recent global financial crisis, accounting up to 14% and 21% of liquidity variations in Asian emerging and developed market respectively. It is not very sensitive to bull-bear market cycles. The large and rising common liquidity component across regional markets has significant implications for international portfolio flows and risk management.

Commonality in news around the world

Motivated by the pioneering study of Morck, Yeung, and Yu (2000), this paper investigates whether and how news commonality varies according to a country׳s institutional environments. Using a unique global news data set across 41 countries for the 2000–2009 period, we document three notable findings. First, firm-level news comoves more in countries with weaker institutional environments than in those with stronger institutional environments. Second, news commonality is positively associated with both stock return comovement and stock liquidity commonality. Third, the effect of news commonality on stock return and liquidity comovement is higher in countries with stronger institutions than in those with weaker institutions. These results suggest that a country׳s institutional environments affect firm-specific information production and, more importantly, support the information-efficiency view that lower price synchronicity is caused by greater capitalization of firm-specific information.

Stock Prices Informativeness, Financial Crisis and Liquidity Commonality: Evidence from Asian Stock Markets

Using a broad set of stocks traded in Asian stock markets from 2000 to 2012, we document that firm-specific commonality in liquidity is positively related with firm-specific stock price synchronicity. Our result suggests that higher firm opacity due to stock price synchronicity increases uncertainty about firm intrinsic value, which in turn causes stock liquidity comovement. However, the adverse impact of firm opacity on commonality in liquidity is not apparent in countries with higher stock market capitalization, lower stock market volatility, higher funding liquidity, and higher interest rate. Concomitantly, higher firm opacity does not exacerbate firm-specific commonality in liquidity when the proportion of firm’s stocks owned by investment firms is low, and the country where the firm is located have better governance quality. During the 2007-2009 crisis period particularly, higher stock market capitalization and funding liquidity as supply-side factors are no longer significant in tempering the positive link between synchronicity and liquidity commonality, while higher correlated trading behavior in exacerbating liquidity commonality is more prevalent in several types of institutional investors.

Uncertainty, market structure, and liquidity

In this study we show that market uncertainty [measured by the Chicago Board Options Exchange Market Volatility Index (VIX)] exerts a large market-wide impact on liquidity, which gives rise to co-movements in individual asset liquidity. The effect of VIX on stock liquidity is greater than the combined effects of all other common determinants of stock liquidity. We show that the uncertainty elasticity of liquidity (UEL: percent change in liquidity given a 1% change in VIX) has increased around regulatory changes in the US markets that increased the role of public traders in liquidity provision, reduced the minimum allowable price variation, weakened the affirmative obligation of NASDAQ dealers, and abolished the specialist system on the NYSE.

Illiquidity Contagion and Liquidity Crashes

Liquidity providers often learn information about an asset from prices of other assets. We show that this generates a self-reinforcing positive relationship between price informativeness and liquidity. This relationship causes liquidity spillovers and is a source of fragility: a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and price informativeness (a liquidity crash). This feedback loop provides a new explanation for comovements in liquidity and liquidity dry-ups. It also generates multiple equilibria.

Illiquidity Contagion and Liquidity Crashes

Liquidity providers often learn information about an asset from prices of other assets. We show that this generates a self-reinforcing positive relationship between price informativeness and liquidity. This relationship causes liquidity spillovers and is a source of fragility: a small drop in the liquidity of one asset can, through a feedback loop, result in a very large drop in market liquidity and price informativeness (a liquidity crash). This feedback loop provides a new explanation for comovements in liquidity and liquidity dry-ups. It also generates multiple equilibria.

Algorithmic Trading and Liquidity Commonality

Although previous research has documented a low intraday liquidity commonality across stocks, it has grown over the past decade. Using the introduction of hybrid market in the New York Stock Exchange, I show that at least a part of this growth can be attributed to an increase in algorithmic trading; hybridization increases the 5-minute liquidity comovement by 30 to 50%. Moreover, the effect is stronger at daily frequencies: hybridization induces a 90% higher daily liquidity co-movement. These results are due to both an increase in market liquidity risk and a decrease in idiosyncratic liquidity volatility.

Forecasting liquidity-adjusted intraday Value-at-Risk with vine copulas

We propose to model the joint distribution of bid-ask spreads and log returns of a stock portfolio by using Autoregressive Conditional Double Poisson and GARCH processes for the marginals and vine copulas for the dependence structure. By estimating the joint multivariate distribution of both returns and bid-ask spreads from intraday data, we incorporate the measurement of commonalities in liquidity and comovements of stocks and bid-ask spreads into the forecasting of three types of liquidity-adjusted intraday Value-at-Risk (L-IVaR). In a preliminary analysis, we document strong extreme comovements in liquidity and strong tail dependence between bid-ask spreads and log returns across the firms in our sample thus motivating our use of a vine copula model. Furthermore, the backtesting results for the L-IVaR of a portfolio consisting of five stocks listed on the NASDAQ show that the proposed models perform well in forecasting liquidity-adjusted intraday portfolio profits and losses.

Liquidity commonality among Asian equity markets

This paper examines the impact of a set of common factors on liquidity variations in twelve Asian equity markets. The cross-market liquidity co-movements, i.e. liquidity commonality, represent an important dimension of capital market integration. I find that (1) liquidity variations in Asian equity markets are increasingly driven by the common factors. By 2009 and early 2010, the common factors account for 15% of daily liquidity variations in Asian emerging markets, and for 22% in Asian developed markets. (2) Volatility as a factor for liquidity commonality is at least as important as the cross-market average liquidity. It explains 12.4% of liquidity variations in Asian developed markets after the global financial crisis. (3) Regional factors affect local market liquidity through shocks in liquidity and volatility. U.S. and U.K. factors have little direct impact on Asian emerging markets. They affect liquidity in Asian developed markets mainly through volatility. The findings shed new light on the level of market integration in Asia and associated liquidity risks.

Liquidity Commonality and Risk Management

We propose to model the joint distribution of bid-ask spreads and log returns of a stock portfolio by using Autoregressive Conditional Double Poisson and GARCH processes for the marginals and vine copulas for the dependence structure. By estimating the joint multivariate distribution of both returns and bid-ask spreads from intraday data, we incorporate the measurement of commonalities in liquidity and comovements of stocks and bid-ask spreads into the forecasting of three types of liquidity-adjusted intraday Value-at-Risk (L-IVaR). In a preliminary analysis, we document strong extreme comovements in liquidity and strong tail dependence between bid-ask spreads and log returns across the firms in our sample thus motivating our use of a vine copula model. Furthermore, the backtesting results for the L-IVaR of a portfolio consisting of five stocks listed on the NASDAQ show that the proposed models perform well in forecasting liquidity-adjusted intraday portfolio profits and losses.