Download Liquidity Risk and Asset Pricing

LIQUIDITY RISK AND ASSET PRICING
for presentation at UESTC, June 2011
Liquidity and Asset Prices
Amihud, Mendelson and Pedersen (2005)

Liquidity is a complex concept.


Stated simply, liquidity is the ease of trading a security.
They review the theoretical literature that


predicts how liquidity affects a security’s required return and
discuss the empirical connection between the two.
Sources of illiquidity

1.) exogenous transaction costs


such as brokerage fees, order-processing costs, or transaction
taxes.
2.) demand pressure and inventory risk

if an agent needs to sell a security quickly,


the seller may sell to a market maker
who buys in anticipation of being able to later lay off the position.
The market maker, being exposed to the risk of price changes

while he holds the asset in inventory,

must be compensated for this risk
 a compensation that imposes a cost on the seller.
Sources of illiquidity_2

3.) adverse information

trading a security may be costly because the traders on the other side
may have private information.
For example,
 the buyer of a stock may worry that

a potential seller has private information that


the seller may be afraid that

the buyer has private information that


the company is losing money, and
the company is about to take off.
Trading with an informed counterparty will end up with a loss.
Sources of illiquidity_3

4.) the difficulty of locating a counterparty

Once a counterparty is located,

the agents must negotiate the price


in a less than perfectly competitive environment
 since alternative trading partners are not immediately available.
A searching trader incurs financing costs or opportunity costs


as long as his trade is delayed, and,
further, he may need to give

price concessions in the negotiation with the counterparty.

Alternatively, he may trade quickly with a dealer and bear illiquidity cost.

In general, a trader faces a tradeoff between

search and quick trading at a discount.
The effects of illiquidity on asset prices

The costs of illiquidity should affect securities prices


if investors require compensation for bearing them.
In addition, because liquidity varies over time,

risk-averse investors may require a compensation for


being exposed to liquidity risk.
These effects of liquidity on asset prices are important.

Investors need to know them in designing their investment strategies.

And if liquidity costs and risks affect the required return by investors,

they affect corporations’ cost of capital and, hence,

the allocation of the economy’s real resources.
Summary

The theory predicts that


both the level of liquidity and liquidity risk are priced.
Empirical studies find the effects of liquidity on asset prices to be

statistically significant and economically important,


Liquidity-based asset pricing empirically helps explain








controlling for traditional risk measures and asset characteristics.
(1) the cross-section of stock returns,
(2) how a reduction in stock liquidity result in a reduction in stock prices and an increase in expected stock returns,
(3) the yield differential between on- and off-the-run Treasuries,
(4) the yield spreads on corporate bonds,
(5) the returns on hedge funds,
(6) the valuation of closed-end funds, and
(7) the low price of certain hard-to-trade securities relative to more liquid counterparts with identical cash flows, such
as restricted stocks or illiquid derivatives.
Liquidity can thus play a role in resolving a number of asset pricing puzzles

such as the small-firm effect, the equity premium puzzle, and the risk-free rate puzzle.
Asset pricing and the bid-ask spread
Amihud and Mendelson (1986)


This paper studies the effect of the bid-ask spread
on asset pricing.
We analyze a model in which
 investors
with different expected holding periods trade
assets with different relative spreads.

The resulting testable hypothesis is that
 market-observed
expected return is an increasing and
concave function of the spread.

We test this hypothesis, and the empirical results
are consistent with the predictions of the model.
Expected return and spread relation
Asset pricing with liquidity risk
Acharya and Pedersen (2005)

This paper solves explicitly a simple equilibrium model with liquidity risk.

In our liquidity-adjusted CAPM, a security’s required return depends



In addition, a persistent negative shock to a security’s liquidity results in


low contemporaneous returns and high predicted future returns.
The model provides a unified framework for understanding the various channels through
which


on its expected liquidity as well as
on the covariances of its own return and liquidity with the market return and liquidity.
liquidity risk may affect asset prices.
Our empirical results


shed light on the total and relative economic significance of these channels and
provide evidence of flight to liquidity.
Liquidity risk


Liquidity risk is often noted in the financial press.
For instance:
 The
possibility that liquidity might disappear from a
market, and so not be available when it is needed, is a
big source of risk to an investor.
 The
Economist, September 23, 1999
Market Liquidity and Funding
Liquidity
Brunnermeier and Pedersen (2008)

Trading requires capital.
 The
funding of traders affects—and is affected by—
market liquidity in a profound way.

When funding liquidity is tight,
 traders
 This

become reluctant to take on positions.
lowers market liquidity, leading to higher volatility.
Further, low future market liquidity increases
 the
risk of financing a trade, thus increasing margins.
Liquidity Spirals
Empirical features of market liquidity

Based on the links between funding and market
liquidity,


they provide a unified explanation for the main empirical
features of market liquidity.
In particular, their model implies that market liquidity
(i) can suddenly dry up,
 (ii) has commonality across securities,
 (iii) is related to volatility,
 (iv) is subject to “flight to quality,” and
 (v) co-moves with the market.

Stock Market Declines and Liquidity
by HAMEED, KANG, and VISWANATHAN (2010,
JF)

Liquidity dry-ups are argued to occur because
 market
participants engage in panic selling (a demand
effect),
 financial intermediaries withdraw from providing
liquidity (a supply effect),
 or both.

This paper explores empirically
 what
happens to market liquidity after large market
declines and
 whether supply effects exist in equity markets.
Theoretical backgrounds:
collateral-based models

In collateral-based models,



market makers make markets by absorbing temporary liquidity shocks.
However, they also face funding constraints and obtain financing by posting margins and pledging the securities they
hold as collateral.
Thus, when stock prices decline considerably,

the intermediaries hit their margin constraints and are forced to liquidate.

This could trigger an illiquidity spiral, further restricting dealers from providing market liquidity. -Brunnermeier and Pedersen (2009),

In Garleanu and Pedersen (2007), tighter risk management by institutions



in response to higher volatility in market downturns
reduces their risk bearing capacity and lowers market liquidity.
They also stress a feedback effect,

where the decrease in market liquidity further tightens risk management.
Theoretical backgrounds:
limits-to-arbitrage models

In limits-to-arbitrage models,



shocks to noise traders make prices move away from fundamentals and
arbitrageurs provide liquidity and take advantage of the arbitrage opportunities.
These liquidity providers

face capital constraints with mark-to-market losses, and



their demand for risky assets declines following market downturns, and
they become liquidity demanders as they liquidate their positions in risky assets.
Mitchell, Pedersen, and Pulvino (2007) show that


convertible hedge funds, which provide liquidity in normal times,
were forced to liquidate their convertible bond positions


due to binding capital constraints following large capital redemptions from investors in 2005 and
the large drop in security values during the LTCM crisis.
Theoretical backgrounds:
coordination failure models

In the coordination failure models,


traders face differing trading limits that cause them to sell.
Since one trader hitting his limit may push down the price



and make other traders’ limits be hit,
early liquidation gives a better price than late liquidation.
Here,


traders rush to liquidate following negative shocks, and
when prices fall enough,

liquidity black holes emerge, analogous to a model of bank runs.
Theoretical predictions


While the exact details of the theoretical models
differ,
they all predict that large market declines

increase the demand for liquidity


as agents liquidate their positions across many assets and
reduce the supply of liquidity

as liquidity providers hit their wealth or funding constraints.
Findings on liquidity_1

large negative market returns have
a
stronger impact on weekly changes in a firm’s bidask spread
 than
positive returns, and
 the
average spread increases by 2.8 (6.2) basis points
after a (large) market decline.

These changes in liquidity last for about 2 weeks
and then
 reverse
in the subsequent weeks.
Findings on liquidity_2

The impact of negative market returns on liquidity is stronger


when financial intermediaries are more likely to face funding
constraints.
For example, negative market returns

reduce liquidity more

when there are also large declines



in the aggregate balance sheets of financial intermediaries or
in the market value of the investment banking sector.
Their findings lend support to the hypothesis that

the relation between liquidity and market declines

is related to changes in the supply of liquidity.
Findings on liquidity commonality

Brunnermeier and Pedersen (2009)suggest that a huge market-wide decline
in prices reduces


the aggregate collateral of the market making sector, which feeds back as
higher comovement in market liquidity.
Indeed, the commonality in liquidity (spreads) increases during periods of
market declines.

The liquidity beta increases by 0.31 (0.39) during periods when the market has
experienced a (large) drop in valuations.

liquidity commonality is positively related to market volatility but unrelated to
idiosyncratic volatility,


indicating that inventory effects are not likely to be the main source.
These findings provide strong support to the idea of

a contagion in illiquidity due to supply effects.
Findings on cost of liquidity provision

using short-term price reversals as our measure of the return to supplying liquidity,

they also examine


In Campbell, Grossman, andWang (1993),



risk-averse market makers require payment for accommodating heavy selling by liquidity traders.
This cost of providing liquidity is reflected in

the temporary decrease in price accompanying heavy sell volume and

the subsequent increase as prices revert to fundamental values.
The zero-cost contrarian investment strategy



if the cost of supplying liquidity depends on the state of market returns.
captureing price reversals on heavy trading
yields an economically significant return of 1.18% per week

when conditioned on large negative market returns, and

is much higher than the unconditional return of 0.58%.
The stronger price reversals in large down markets

last up to 2 weeks,

are higher in periods of high liquidity commonality, and

cannot be explained by standard Fama–French (1993) risk factors.
Conclusion

By investigating the impact of market declines on
various dimensions of liquidity, including:
 (1)
time-series as well as cross-sectional variation in
liquidity;
 (2) commonality in liquidity; and
 (3) cost of liquidity provision,
 their
 the

cumulative findings are consistent with
collateral-based view of liquidity
put forward in recent theoretical papers.
Stock Market Liquidity and the Business Cycle
Nas et al. (2010, JF, forthcoming)

stock market liquidity tends to dry up
 during

What is the causality between
a

economic downturns.
decline in market liquidity and the economic crisis?
This paper shows:
 Stock
market liquidity is a very good “leading
indicator” of the real economy.
Links from trading costs to the real economy
_US evidence

The observed effects could be the results of
 aggregate
 where


changes in desired portfolios are driven by
changes in individuals' expectations of the real economy.
This is an example of the well known idea of
a

portfolio shifts from investors,
“flight to quality“ or “flight to liquidity.“
The main source of the predictability is reflected in
 the
liquidity variation of small, relatively illiquid,
stocks.
Links from trading costs to the real economy
_evidence from Norway

confirm the US results that


link changes in liquidity to


changes in the portfolio composition of all investors in Norway.
show that periods when liquidity worsens are



stock market liquidity contains information about the macro economy.
the same as periods
when there is a “flight to quality" in the stock portfolios of owners.
imply that systematic liquidity variation is related to

a “flight to quality“ during economic downturns.