Illiquidity Measure Research Articles

Pricing of time-varying liquidity risk in Finnish stock market: new evidence

ABSTRACTUsing two recently developed illiquidity measures, we estimate a conditional version of liquidity-adjusted capital asset pricing model (LCAPM), which allows for a time-varying decomposition of the total illiquidity premium into a level component and three risk components. The total estimated annualized illiquidity premium for the Finnish equities during 1997–2015 is 1.13–1.90% depending on the illiquidity measure. Of the three systematic liquidity risk components, risk arising from hedging of wealth shocks is the most important followed by commonality in liquidity risk, whereas flight to liquidity risk is not significantly priced in the Finnish stock market. Our results show that the liquidity risk is time varying, therefore the models estimating the risk-return relationship should address the issue of conditionality.

Bond Liquidity, Risk Taking and Corporate Innovation

This paper investigates how market liquidity condition of corporate bonds can affect firm investment policy, specifically its risk taking. We hypothesize that bond liquidity can affect firm's risk taking via the disciplinary function of trading. Indeed, we document a positive relationship between bond illiquidity and firms' risk taking, specifically a one standard deviation in Amihud illiquidity measure is associated with nearly 20% increase in investment ratio. Using introduction of TRACE in 2002 as an exogenous shock to bond trading infrastructure, our findings suggest that the relationship is causal. Finally, we document that the shift in risk taking increase the volume but not necessarily the quality of innovation output. Our empirical results have important implications for firms risk policy and growth as well as for designing of market microstructure.

The Informational Dimensions of the Amihud (2002) Illiquidity Measure

In this study we shed a new light on Amihud’s illiquidity measure, used here as a relevant measure of consensus belief among investors about new information (Amihud, 2002). This paper demonstrates the relevance of this new approach/dimension in the context of M&A transactions. Using a large sample of M&A in the U.S., Canada and Europe over the 2000-2013 period, we report that Amihud’s (2002) measure is a significant determinant of cumulative abnormal returns observed after M&A. This metric is also consistent with financial analyst forecast activity and stands as a relevant proxy measure of price informativeness.

Market Illiquidity Premium on Stock Returns: An Empirical Study of Taiwan Stock Markets

This paper examined the existence of illiquidity premiums in Taiwan stock markets during 1982-2016. First, the illiquidity premium was calculated with the method of Amihud (2014) in a whole period and its three sub periods, and then a five-factor model was formed by adding the new risk premium to the traditional Fama-French-Carhart four-factor model. Then quint portfolios the illiquidity measure by Amihud (2002) in an ascending order and applies factor models to explore the relationship between stock returns and illiquidity premium. The empirical results indicated that the five-factor model increased the relative explanatory power compared to the traditional four-factor model. For the higher illiquidity portfolios, the illiquidity premium demonstrated significantly positive effects on stock returns and the five-factor model showed relatively smaller alphas, which in turn proved the existence of market illiquidity premiums. The empirical results are expected to enhance the understanding of the functioning of illiquidity on developed markets in the literature, and also add more evidence on the emerging market settings.

The impact of illiquidity risk for the Nordic markets

ABSTRACTIn this study, we propose a new measure of illiquidity for small, open stock markets; dollar zero-returns. Compared with other commonly used measures of illiquidity, the dollar zero-return produces the highest anomalous return across all four Nordic markets. In testing the pricing implication of the proxies of illiquidity, we use liquidity adjusted asset pricing models suggested in the literature for a panel of 25 size-related portfolios for the Nordic markets. Our results show that the only illiquidity measure that gives a significant positive effect across all Nordic markets is the dollar zero-return. Our results also show that the illiquidity mimicking portfolio factor, constructed through dollar zero-return, is the only factor showing a significant premium across different specifications, and its pricing remain significant also when the effect of the level of illiquidity (constructed through all measure of illiquidity) and of size is netted out.

Volatility Derivatives and Market (Il)liquidity

We study how derivatives (with nonlinear payoffs) affect the liquidity of the underlying asset. In a rational expectations equilibrium, informed investors expect low conditional volatility and sell derivatives to the others. These derivative trades affect investors’ utility differently, possibly amplifying liquidity risk. As investors delta hedge their derivative positions, price impact in the underlying drops, suggesting improved liquidity, because informed trading is diluted. In contrast, effects on price reversal are ambiguous, depending on investors’ relative delta hedging sensitivity, i.e., the gamma of the derivatives. The model cautions of potential disconnections between illiquidity measures and liquidity risk premium due to derivatives trading.

Testing the new Fama and French factors with illiquidity: A panel data investigation

Nous investiguons les cinq nouveaux facteurs de Fama et French (2015, 2016) rehaussés d’une mesure de liquidité bien connue (Pástor and Stambaugh, 2003) à l’aide d’une version du GMM qui recourt à des instruments robustes, cela dans le cadre d’une analyse en panel. Lorsque nous recourons à l’estimateur OLS, notre version du modèle de Fama-French semble avoir un pouvoir explicatif en regard des rendements d’un portefeuille à douze secteurs. Cependant, notre étude en panel suggère que le seul facteur significatif est la prime de risque du marché. Dépendamment de la technique utilisée, nous trouvons que les erreurs de mesure peuvent être à la source de ce résultat, ce qui tend à appuyer le modèle élargi de Fama-French. Comme test de robustesse, nous expérimentons également avec d’autres mesures de liquidité, telles que le ratio d’Amihud (2002) et la prime à terme, ainsi qu’avec des facteurs reliés aux marchés obligataires. Les résultats sont plutôt inchangés pour nos 12 portefeuilles. Nous testons également notre modèle élargi sur des portefeuilles gérés – i.e., des fonds de couverture (hedge funds). Ces portefeuilles semblent mieux adaptés au modèle élargi de Fama-French qui inclut des mesures de liquidités, et plus spécialement lorsque l’on introduit la crise des subprimes . Les nouveaux facteurs de Fama-French semblent également être très sensibles à nos mesures d’illiquidité.

Do Post-Crisis Regulations Affect Market Liquidity? Evidence from the Co-Movement of Stock, Bond, and CDS Illiquidity

Using both market-wide and firm-level illiquidity measures of the stock, bond, and CDS markets, we find that the co-movements of illiquidity across markets increase significantly during the recent global financial crisis. Moreover, the degree of co-movements remains significantly higher in the post-crisis period and regulatory period than in the pre-crisis period. Specifically, the distribution of firm-level co-movements is notably different before and after the crisis (e.g., a much larger portion of firms with positive pairwise correlations between illiquidity measures in the post-crisis period than in the pre-crisis period). Our results provide suggestive evidence of the effects of financial crisis and the subsequent post-crisis regulations on the co-movements of illiquidity across markets.

What Does the Prevalence of Zero Returns Tell Us about Jump Identification? Evidence from U.S. Treasury Securities

We document that each day the U.S. Treasury notes have a large proportion of zero returns, because the vast majority of trades are executed at the best ask/bid quotes and spreads are mostly set close to the minimum tick. The proportion of zero returns is negatively correlated with traditional illiquidity measures. Given the distinctive feature (frequent zero returns), conventional jump-detection methods are vulnerable to biases, leading to falsely identifying jumps. We propose a low-cost solution to the biases, and empirically support the arguments by comparing the identification results using the actual data on the Treasury notes and macro-economic news announcements.

It Takes Two to Tango: Fundamental Timing in Stock Market

In this paper, we propose a fundamental timing strategy in both U.S. and Chinese stock market to trade the fundamental sorted portfolios such as value and profitability portfolios in the time series dimension. We find that fundamental timing strategies based on moving average (MA) timing signals could generate substantial performance improvements relative to corresponding buy-and-hold fundamental strategies. The annualized average return of the 20-day MA fundamental timing strategies reaches about 37% with Sharpe ratio nearly 1.30. These findings are robust to Fama-French factor model adjustment, alternative lag lengths of MA signals, holding days, and transaction costs. Moreover, we find that the fundamental timing premium cannot be explained by market timing ability or business cycle, and fundamental timing is more profitable among firms with high idiosyncratic volatility and high illiquidity measures.

The maximum bid-ask spread

We examine the return premium associated with a new measure of illiquidity that focuses on extreme points in the distribution of bid-ask spreads. Results show that stocks with larger maximum bid-ask spreads and price impacts command a return premium that is both statistically and economically significant. These results are robust to a series of multifactor portfolio tests and cross-sectional regressions controlling for mean spreads and other observable liquidity metrics. These findings suggest that the distribution of spreads matters when identifying illiquidity return premia due to the multi-faceted nature of liquidity.

Stock Illiquidity and Firm Characteristics

Main objective of the study is to analyze firm characteristics which affect stock illiquidity. The paper aims to give suggestions and policy implications to corporates and investors while dealing with investments in illiquid stocks. ANOVA, chi-square tests, correlation analysis, univariate and multiple regression models are employed on Amihud (2002) (Amihud, Y., (2002). Illiquidity and Stock Returns: Cross-Section and Time-Series Effects, Journal of Financial Markets 5, 31–56) illiquidity measure and various firm characteristics. Findings of this paper suggest that firms with illiquid stocks can be characterized with low promoter’s stakes, high leverage, poor financial health, small size and low/negative profitability. The findings of the paper will be of relevance to retail investors who are at the mercy of informed investors. The results portray basic characteristics that an investor should look into before investing in any stock. The study is of value to the investors who are grieved because of the adverse selections and information asymmetry. Moreover, the basic nature of illiquid firms has never been studied.

Illiquidity in the Japan electric power exchange

Historical data of system prices and trading volumes of electric power over the 48 half-hour intra-daily intervals in the Japan Electric Power Exchange (JEPX) from August 2005 to March 2015 are analyzed. The data allow me to compute several representative measures of economic illiquidity, namely, Amihud's price-impact measure, Roll's implied spread cost measure, and an idiosyncratic volatility measure. Based on a dynamic panel regression framework allowed by a panel reinterpretation of the data, I establish that (a) these illiquidity measures comove to some extent, (b) a higher trading volume of electric power does not lower the spread cost, (c) a positive contribution of the price-impact measure to the return is stronger than that of the spread cost, (d) the great earthquake might disturb the risk-return tradeoff, and (e) a negative return-volatility relationship may stem from overlooked upward spikes in electric power prices.

Testing extensions of Fama & French models: A quantile regression approach

This research compares twelve different factor models in explaining variations in U.S. sector returns between Nov. 1989 and Feb. 2014 using the quantile regression approach. Specifically, these models rely on the Fama and French three- and five-factor models (1993 and 2015), adding other explanatory factors such as nominal interest rates, and its components: real interest and expected inflation rates, the Carhart (1997) risk factor for momentum and for momentum reversal and the Pastor and Stambaugh (2003) traded liquidity factor. Additionally, for robustness, this paper includes the alternative Amihud (2002) illiquidity measure, as well as analyses the validity of the proposed models, depending upon the stage of the economy, by distinguishing between recession and expansion sub-periods. This paper concludes that the most complete model shows the highest explanatory power. Furthermore, the extreme quantile 0.1 of the return distribution shows the best results in all the factor models, and some sectors, such as Industrials and Financials, consistently evidence more statistically significant coefficients and thus higher Adj. R2 values in the total sample as well as in recession and expansion sub-periods. In contrast, the Utilities sector consistently shows the lowest explanatory power for all the models, quantiles and periods.

The Impact of Introducing REITs on Foreign Investments and Liquidity in South Africa

More than 30 countries have introduced real estate investment trusts (REITs). One main objective is to attract foreign investors and improve the liquidity of the respective listed property sector. We investigate whether the introduction of REITs meets this objective by using the South African listed property sector as a laboratory. In particular, we employ panel data to investigate whether converting to REITs improved the liquidity of listed South African property firms through foreign investments. We find that foreign investor trading after the introduction of REITs has a significantly positive impact on activity measures such as turnover and trading volume. On the other hand, the significantly negative impact of foreign investor trading on friction measures such as bid-ask spread and Amihud's (2002) illiquidity measure, which was prevalent in the pre-REIT period, disappears once REITs were introduced. Thus, the introduction of REITs eliminated the impact of foreign investments on the depth and tightness of the listed property market in South Africa.

The impact of internationalisation on stock liquidity and volatility: Evidence from the Johannesburg Stock Exchange

Maximising firm value remains a key tenet of corporate managers. Firms with lower illiquidity and volatility attract lower risk premiums, and these are associated with a lower cost of capital and higher firm value. Internationalisation is one avenue purported to provide liquidity and volatility benefits – possibly lowering both liquidity and volatility risk premiums. This study investigated whether South African domiciled stocks experience a surge in liquidity and/or decline in volatility subsequent to internationalisation. The findings show that internationalisation resulted in a surge in liquidity, and this increase was persistent as suggested by the trading volume and Amihud illiquidity measures of stock liquidity; however, the turnover measure indicated that such liquidity gains were temporary. Similarly, volatility declines after internationalisation were temporary. There was inconclusive evidence to show that internationalised stocks had higher liquidity relative to purely domestic shares, and no statistically significant difference between the volatility of internationalised and purely domestic shareholders’ equity was noted. There is only weak evidence to support internationalisation as a route for lowering cost of capital via a reduction in the liquidity risk premium.

Do Proxies for Informed Trading Measure Informed Trading? Evidence from Illegal Insider Trades

This paper exploits hand-collected data on illegal insider trades to test whether standard illiquidity measures can detect informed trading. Controlling for unobserved cross-sectional and time-series variation, sampling bias, and strategic timing of insider trades, I find that only absolute order imbalance and the negative autocorrelation of order flows are statistically and economically robust predictors of insider trading. However, this result only holds for short-lived information. When information is long-lived, none of the measures of illiquidity I consider detect informed trading, including bid-ask spreads, Kyle's lambda, and Amihud illiquidity. These results suggest that standard measures of illiquidity have limited applications.

Illiquidity Premia in the Equity Options Market

Standard option valuation models leave no room for option illiquidity premia. Yet we find the risk-adjusted return spread for illiquid over liquid equity options is |$3.4\%$| per day for at-the-money calls and |$2.5 \%$| for at-the-money puts. These premia are computed using option illiquidity measures constructed from intraday effective spreads for a large panel of U.S. equities, and they are robust to different empirical implementations. Our findings are consistent with evidence that market makers in the equity options market hold large and risky net long positions, and positive illiquidity premia compensate them for the risks and costs of these positions. Received September 25, 2012; editorial decision September 17, 2017 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

(Pro?)-Cyclicality of Collateral Haircuts and Systemic Illiquidity

Pro-cyclicality of collateral haircuts and margins has become a widely proclaimed behavior and is currently discussed not only by academic literature but also by regulatory authorities in Europe. Pro-cyclicality of haircuts is assumed to be a trigger of liquidity spirals due to its tightening effect of collateral portfolio values in times of market distress. However, empirical evidence on this topic is quite sparse and the discussions are primarily driven by insights derived from theoretical models. Nonetheless, oversight bodies are discussing macroprudential haircut add-ons in order to curb with the potential effects of pro-cyclicality in distressed periods. Based on a unique data set provided by a large European Central Counterparty we construct a measure of systemic illiquidity of bond collaterals and analyze the relationship between haircuts, the development of periods with explosive behavior and systemic illiquidity. We estimate the noise of bond yields to measure systemic illiquidity with and without considering haircuts. We then apply an explosive roots bubble detection technique to identify irrational periods of each of these two time series and to a combination of both. Finally, we propose a quantitative trigger and design for macroprudential haircut add-ons. Our results confirm that (1) bond collateral markets face irrational, i.e. bubble-like illiquidity during periods of systemic distress. The results indicate that (2) haircuts are not amplifying or increasing with systemic illiquidity. (3) The proposed haircut add-on mechanism exhibits desirable features to mitigate systemic illiquidity during lasting periods of distress.

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.