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Liquidity Risk

Paper Session

Sunday, Jan. 5, 2020 10:15 AM - 12:15 PM (PDT)

Manchester Grand Hyatt, Seaport B
Hosted By: American Finance Association
  • Chair: Rui Albuquerque, Boston College

The Pricing of the Illiquidity Factor’s Conditional Risk with Time-varying Premium

Yakov Amihud
,
New York University
Joonki Noh
,
Case Western Reserve University

Abstract

We test the pricing of the conditional systematic risk (β) of a traded illiquidity factor IML, the return premium on illiquid-minus-liquid stocks, when its risk premium is allowed to vary over time. We find a positive and significant risk premium on conditional IML β that rises in times of financial distress, measured by the corporate bond yield spread or broker–dealer loans (including margin loans). Notably, the conditional IML β is unique in being significantly priced across individual stocks. None of the unconditional and conditional βs of Fama-French-Carhart factors is consistently and significantly priced nor are the βs of popular alternative liquidity-based factors.

Liquidity, Volume, and Volatility

Vincent Bogousslavsky
,
Boston College
Pierre Collin-Dufresne
,
Swiss Federal Institute of Technology-Lausanne (EPFL)

Abstract

We examine the relation between liquidity, volume, and volatility using a comprehensive sample of U.S. stocks in the post-decimalization period. For large stocks, effective spread and volume are positively related in the time series even after controlling for volatility, contrary to most theoretical predictions. This relation is mostly driven by the systematic component of volume. In contrast, for small stocks the evidence matches the predictions of standard adverse selection models. In line with a continuous-time inventory model, we show that the volatility of order imbalances can reconcile our puzzling finding with standard intuition. Order imbalance volatility is strongly associated with spreads both in the time series and cross-section. Evidence from alternative liquidity measures (price impact and depth), spread decomposition, and intraday patterns support our interpretation of order imbalance volatility as a measure of inventory risk. Furthermore, order imbalance volatility is priced in the cross-section of weekly returns.

Liquidity Creation as Volatility Risk

Itamar Drechsler
,
University of Pennsylvania
Alan Moreira
,
University of Rochester
Alexi Savov
,
New York University

Abstract

We show, both theoretically and empirically, that liquidity creation induces negative exposure to volatility risk. Intuitively, liquidity creation involves taking positions that can be exploited by privately informed investors. These investors' ability to predict future price changes makes their payoff resemble a straddle (a combination of a call and a put). By taking the other side, liquidity providers are implicitly short a straddle, suffering losses when volatility spikes. Empirically, we show that short-term reversal strategies, which mimic liquidity creation by buying stocks that go down and selling stocks that go up, have a large negative exposure to volatility shocks. This exposure, together with the large premium investors demand for bearing volatility risk, explains why liquidity creation earns a premium, why this premium is strongly increasing in volatility, and why times of high volatility like the 2008 financial crisis trigger a contraction in liquidity. Taken together, these results provide a new, asset-pricing view of the risks and rewards to financial intermediation.

Trading Volume, Illiquidity and Commonalities in FX Markets

Angelo Ranaldo
,
University of St. Gallen
Paolo Santucci de Magistris
,
Guido Carli University (LUISS)

Abstract

In a regime of floating FX rates and open economies, it is important to understand how FX rates, volatility, and trading volume interrelate. To uncover this, we provide a simple theoretical framework to jointly explore these factors in a multi-currency environment. Through the use of unique intraday data representative of the global FX market, the empirical analysis validates our theoretical predictions: (i) more disagreement increases FX trading volume, volatility, and illiquidity (ii) stronger commonalities pertain to more efficient (arbitrage-free) currencies, and (iii) the high-frequency Amihud (2002) measure, for which we provide a theoretical underpinning, is effective in measuring FX illiquidity.
Discussant(s)
Jeffrey Pontiff
,
Boston College
Haoxiang Zhu
,
Massachusetts Institute of Technology
Mark Westerfield
,
University of Washington
Pasquale Della Corte
,
Imperial College London
JEL Classifications
  • G1 - General Financial Markets