Market Illiquidity Research Articles

Funding Illiquidity Implied by S&P 500 Derivatives

Based on the typical positions of S&P 500 option market makers, we derive a funding illiquidity measure from quoted prices of S&P 500 derivatives. Our measure significantly affects the returns of leveraged managed portfolios; hedge funds with negative exposure to changes in funding illiquidity earn high returns in normal times and low returns in crisis periods when funding liquidity deteriorates. The results are not driven by existing measures of funding illiquidity, market illiquidity, and proxies for tail risk. Our funding illiquidity measure also affects leveraged closed-end mutual funds and, to an extent, asset classes where leveraged investors are marginal investors.

Short-term contrarian in the carbon emission market

We consider the short-term contrarian effects in daily data from carbon emission markets. Technical analysis is conducted with three contrarian trading rules on four carbon emission markets of China. Various individual and joint test statistics are developed for testing the contrarian profits from individual trading path as well as a group of trading paths. Empirical evidence shows that the contrarian profits are statistically and economically significant across the technical rules. Particularly, the contrarian moving average group trading generates average returns of 3.8 to 13.8 % per month across the different carbon markets during the period of 2013–2023 and the corresponding Sharpe ratios range from 0.9 to 2.01, while the Sharpe ratios from the buy-and-hold strategy are all below 0.12. Further tests support that the contrarian profits are not eliminated by transaction costs, and not dominated by extreme returns. We also emphasize on the explanations of the contrarian profit. Among the considered variables, the market volatility is the most significant explanatory variable for contrarian profits across four markets, whereas the market illiquidity and non-trading breaks are also significant in certain markets. The finding supports the explanation of the behavioural bias of overreaction for the short-term contrarian effect. Other explanations, including short-selling constraint, clearing stress, price limits, government interventions, etc. are also discussed in the paper.

Monetary policy and fragility in corporate bond mutual funds

We document aggregate outflows from corporate bond mutual funds days before and after the announcement of increases in the Federal Funds Target rate (FFTar). To rationalize this phenomenon, we build a model in which funds’ net-asset-values (NAVs) are stale and investors strategically redeem to profit from the mispricing when they learn about the increases of FFTar. Consistent with the model’s predictions, we find that stale NAVs and loose monetary policy environments weaken (strengthen) outflows sensitivity to increases in FFTar during illiquid (liquid) market conditions. Our results highlight when and how monetary policy could systematically exacerbate the fragility of corporate bond funds.

Product market competition, debt rollover risk and financial default risk: evidence from Indian corporates

PurposeThe study investigates the impact of the interaction effect of product market competition and rollover risk on the default risk of the firms.Design/methodology/approachThe study used the sample of unbalanced panel data from Indian corporates without any survivability bias over the period from 2009 to 2020 consisting of 30,396 firm-year observations of 6,718 firms spread across 143 industry groups. The panel data regression tests the interaction effect in the context of the asset substitution problem, predation threat theory, competitive shock, and competitive risk.FindingsThe empirical results highlighted the dominance of the predatory effect of competition over the disciplinary advantage of short-term debts. The competitive shock to the industry results in a higher credit spread for refinancing short-term debt and significantly increases rollover risk for firms. Smaller firms have higher default risk from rollover losses than larger firms in the face of competition due to asset-substitution problems and strong rivalry. For firms with weaker fundamentals, the interaction effect of rollover risk and competition exacerbates the flight-to-quality problem, resulting in a systemic event.Practical implicationsThe investors can benefit by factoring ex-ante the interdependence of competition, debt market illiquidity, and default premia while calculating the credit risk. The shareholders of competitive firms can reduce the moral hazard of refinancing the rollover losses and defaulting at a higher fundamental default threshold, by reducing sub-optimal utilization of funds by managers and agency costs.Originality/valueAs per the best of author knowledge, the present study is the first to study the moderating effect of product market competition in exacerbating default risk through the rollover channel.

Valuing Financial Data

Abstract How should an investor value financial data? The answer is complicated because it depends on the characteristics of all investors. We develop a sufficient statistics approach that uses equilibrium asset return moments to summarize all relevant information about others’ characteristics. Our approach values public or private data, data about one or many assets, and data relevant for dividends or sentiment. While different data types, of course, have different valuations, heterogeneous investors also value the same data very differently. This finding suggests a low price elasticity for data demand. Heterogeneous investors’ data valuations are also affected very differentially by market illiquidity.

Firm visibility, liquidity, and valuation for thinly traded assets

We employ a regression discontinuity design to study how a market division experiment affects stock liquidity and firm valuation in an illiquid market. We document that an increase in firm visibility can substantially improve a firm's liquidity (measured by trading immediacy) and increase valuation by 28.4% for thinly traded assets. We also find some evidence that an improved information environment may contribute to enhanced liquidity and valuation.

Does ownership concentration affect corporate bond volatility? Evidence from bond mutual funds

This paper examines the link between ownership concentration and corporate bond volatility. We show that more concentrated mutual fund ownership is associated with higher volatility of corporate bonds. This relation is stronger among more illiquid bonds, during periods of heightened bond market illiquidity, and among bonds held by corporate bond funds that invest in more illiquid bonds and experience higher or more correlated liquidity shocks. Using a sample of mutual fund mergers, we further show that increases in bond volatility are unlikely to be driven entirely by the endogenous ownership structure of corporate bonds. Our findings suggest that the concentrated ownership by corporate bond mutual funds provides another channel, apart from illiquidity, to help explain the excess volatility in corporate bonds.

Inflation Expectations, Liquidity Premia and Global Spillovers in Japanese Bond Markets

We provide market-based estimates of Japanese inflation expectations using an arbitrage-free dynamic term structure model of nominal and real yields that accounts for liquidity premia and the deflation protection afforded by Japanese inflation-indexed bonds, known as JGBi’s. We find that JGBi liquidity premia exhibit significant variation, and even switch sign. Properly accounting for them significantly lowers the estimated value of the indexed bonds’ deflation protection and affects inflation risk premium estimates. After liquidity adjustment, long-term Japanese inflation expectations have remained relatively stable at levels modestly exceeding one percent during the pandemic period. We then utilize our estimated liquidity measure to confirm the existence of statistically significant and economically meaningful spillovers to the JGBi market from global bond market illiquidity, as proxied by periods of low U.S. Treasury market depth.

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.

Predictive Distributions and the Market Return: The Role of Market Illiquidity

Predictive Distributions and the Market Return: The Role of Market Illiquidity

Foreign institutions, local investors and momentum trading

We study momentum and contrarian trading of foreign and local institutions as well as local individuals using a unique ownership dataset from the Australian stock market. We find that foreign institutions are momentum investors, whereas local investors are contrarians. However, momentum trading by foreign institutions is reversed during the Global Financial Crisis indicating that their trading behavior is time-varying. We further show that momentum trading by foreign institutions decreases following a period of low market return, high market illiquidity, high market volatility, or high volatility of the momentum portfolio. Also, momentum trading by foreign institutions predicts momentum profits. We show that the disposition effect partly explains the contrarian trading by local investors, suggesting that foreign institutions’ tendency to momentum trading cannot be solely attributed to their liquidity provision to local investors.

INDONESIA’S STOCK MARKET LIQUIDITY: THE IMPACT OF COVID-19 PANDEMIC AND SOCIAL DISTANCING

The purpose of this study was to obtain empirical evidence regarding the effects of COVID-19 pandemic on Indonesia’s Stock Market Liquidity. COVID-19 was observed with three variables (the growth of the total number of confirmed cases, the growth of the number of deaths, and stringency index). This study incorporated market capital, return of Jakarta Composite Index (JCI), and exchange rates of Rupiah against U.S. Dollar as control variables. The source of data of this research was from IHSG transactions, COVID-19 updates on WHO’s website, and exchanges rate historical data from Bank Indonesia’s website from March 2nd, 2020 to December 30th, 2020. Hypothesis testing is done by multiple regression analysis using EViews 12. The findings of this research indicate that COVID-19 did not correlate significantly to the liquidity by the depth measure. The implication of this study is to provide new insight regarding the effects of pandemic towards Indonesia’s stock market liquidity, to become a reference to the future research because the result differs from one country to another one, to provide new insight such as knowledge regarding the higher return and the strengthening of Rupiah means the higher stock market illiquidity by its depth, in order to give guidance for investors’ decision-making process and to give references for the next research.

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.

Optimal Investment in an Illiquid Market with Search Frictions and Transaction Costs

Optimal Investment in an Illiquid Market with Search Frictions and Transaction Costs

Estimating Risk in Illiquid Markets: A Model of Market Friction with Stochastic Volatility

Abstract This article deals with the problem of estimating the volatility of a financial security in a market with frictions. We propose a microstructural model with time-varying fundamental price volatility in which the trading price varies only if the value of the information signal is large enough to guarantee a profit in excess of transaction costs. Using transaction data only, the proposed approach allows to recover: (i) the conditional volatility of the information signal, which is thus cleaned out by market frictions and (ii) an estimate of transaction costs. Our analysis reveals that, after correcting for frictions, the risk of illiquid securities is substantially different from what is predicted by traditional volatility models. Furthermore, using a big dataset of intraday returns, we show that our transaction cost estimate is highly correlated with the main illiquidity measures and that such correlations are significant under different volatility regimes.

Firm‐level political risk and implied cost of equity capital

AbstractI find a strong positive association between firms' implied cost of equity capital and firm‐level political risk. This effect is above and beyond the firm‐level cost of equity implications of economywide political risk. Firm‐level political risk contributes to elevating stock illiquidity, increases dispersion of analyst forecasts and dampens analyst coverage and these attributes, in turn, have positive cost of equity capital implications. Overall, the findings of this study suggest firm‐level political risk has a non‐trivial effect on increasing equity market illiquidity, increasing dispersion of earnings forecasts and decreasing analyst coverage thus increasing financing costs.

Sequential entry in illiquid markets

I study the sequential entry of intermediaries into an illiquid market. As intermediaries trade with rational counterparts, market depth affects and is affected by the possibility of entry. This feedback loop between entry and depth gives incumbent intermediaries more incentives to deter entrants, creating endogenous barriers to entry. Further, whether entry occurs or not in equilibrium has distinct effects on market quality: while entry improves depth, reduces spreads, and speeds up price convergence, the threat of entry disciplines only spreads. In a contestable market, more competition leads to higher spreads and intermediaries’ counterparties benefit more from deterrence than actual entry.

EX ANTE PREDICTABILITY OF STOCK RETURNS IN A FRONTIER MARKET

This study reports results on the ex ante predictability of stock returns using real-time stock market data in Vietnam, a frontier market, from June 2008 to June 2021. Countries classified as a frontier market are often known for currency manipulation, financial market illiquidity, and political instability. Despite the enormous risk usually posed by these inefficiencies, potential profits are large and achievable for many investors. This study provides evidence on existing a strategy to form out-of-sample long portfolios that generate statistically significant and positive mean monthly returns even in the presence of transaction costs. I also justify the magnitude of these returns by showing that they exceed those of VnIndex and MSCI Vietnam Index. The results reject the hypothesis that the stock prices in Vietnamese market follow random walks, thus oppose the stock market efficiency hypothesis. Evidence found in this study provides a better understanding of informational efficiency in a frontier equity market setting. Specifically, there are several implications on portfolio selection strategies, stock price patterns, and trading behavior bias related to Vietnamese stock market can be drawn from this study.

Stock Market Liquidity during Periods of Distress and its Implications: Evidence from International Financial Markets

Traditional market pricing models assume frictionless markets with abundant liquidity. This traditional models also incorporate stock market liquidity as an exogenous cost. However, this paradigm has many shortcomings due to its inability to explain some of the problems associated with security market illiquidity. The aim of this study was to explore the concept of stock market liquidity during periods of financial distress. A Markov switching GARCH model was used to investigate market liquidity in the CAC 40, DAX, JSE, Nasdaq Index and the Nikkei-225 during the 2007-2008 financial crisis and the Covid-19 pandemic. The sample period was January 1, 2020 to December 31, 2021 and December 1, 2007 to June 30, 2009. From the findings, some financial markets where still liquid despite the financial crisis with the exception of the Nasdaq index. Conversely, all the financial markets under consideration displayed strong illiquidity during the covid-19 pandemic. In essence, the level of market depth has significantly decreased from the financial crisis to the covid-19 pandemic which may be attributed to increasing margin requirements and information asymmetry as well as price restrictions. There is an urgent need for regulatory authorities to review some of the trading regulations during financial distress.

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.