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Stock Market Liquidity and Country Fundamentals Ser-Huang Poon Michael Rockinger Konstantinos Stathopoulos 1 Risk Management Consideration n Liquidity adj-VaR VaR i 12 si i 1 n is the number of positions i is the dollar investment in ith position si is the percentage bid-ask spread n is not the problem but i 1 i is n si is potentially a function of i Instead of spread, one could use price impact also. 2 Amihud (2002) Illiquid if price impact is high: ILi ,t ILm ,t Ri ,t $volumei ,t 1 Mt Mt IL i 1 i ,t ln PI i ,t Voli ,t trend i ,t i ,t $volumei ,t exp 3 What drives liquidity (in different countries)? • Country fundamentals • Computer technology, automated trading • Liquidity funding management and territory of operation • Risk regulations and territorial divide 4 Liquidity Black Hole • Liquidity dries up during sell-off and asset can be sold only at a fire-sale price (price decline scenario). • Computer models used by different traders are similar. • Financial institutions are regulated in the same way and respond the same way to changes in volatility and correlation. • Herding • Liquidity funding management 5 “Amihud’s email” • Volatility of economic variables • Legal variables • Country economic variables 6 Legal Variables • Legal origin • Financial regulation - Insider trading and other laws • Enforcement variables 7 Volatility of Economic Variables • Volatility of industrial production or other index of economic activity • Volatility of monetary variables - Various definition of money - Interest rate 8 Country Economic Variables • Per capita income, growth, new investment, new firms • Investment by individuals (India, China) • Institution’s activity (% managed by funds) • Market cap compared to economy • Measure of float(???), in some countries, the market float is large but the float is small. 9 Capital Market Governance Daouk, Lee and Ng (2006, JCF) • CMG index • Earnings opacity • Enforcement of insider laws, • Removal of short selling restrictions • Performance • Low cost of equity • High liquidity • Efficient pricing 10 11 12 Capital Market Governance Daouk, Lee and Ng (2006, JCF) • 32 countries; Not focus on “crisis” • Good governance => good performance => liquidity • Not focus on “crisis” 13 Sample: 37 Stock Markets 1996-2007 Europe Austria Belgium France Germany Italy Portugal Switzerland UK SE. Asia HK Indonesia Japan Korea Malaysia Philippine Singapore Taiwan Thailand Latin Argentina Chile Colombia Mexico Peru Venezuela E.Europe Czech Poland Russia? Turkey? Scandinavian Denmark Finland Norway Sweden Others Australia China India Israel South Africa 14 Illiquidity Measure 1 Indonesia Philippines India HK Germany SouthAfrica Mexico Singapore Thailand Korea Israel Malaysia Poland Australia Argentina USA Japan Sweden Turkey Norway Portugal Finland UK Denmark Peru France Taiwan Czech Switzerland Chile Belgium China Italy Austria Russia Colombia Venezuela 0 5 10 15 20 25 30 35 40 15 Illiquidity Measure 2 Philippines Indonesia India Germany USA Israel HK Japan SouthAfrica Argentina Korea Australia Singapore Thailand Turkey Malaysia Sweden Mexico Finland Portugal Switzerland France Denmark Norway Peru Belgium Taiwan UK China Poland Italy Austria Czech Chile Russia Colombia Venezuela 0 1 2 3 4 5 6 7 8 16 Illiquidity Measure 3 Colombia UK Chile Mexico Peru Venezuela Russia Czech Philippines Argentina Germany SouthAfrica Portugal Norway Austria Denmark Belgium Indonesia Sweden Thailand USA France Switzerland Finland Australia Israel India Italy HK Singapore Malaysia Poland Japan Korea Turkey Taiwan China 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 17 Regional Illiquidity Measures (Mean) 14 12 IL1 IL2 IL3 10 8 6 4 2 0 Latin Europe Scandinavian Asia USA 18 Illiquidity Measures (Mean) by Legal Origin 9 8 IL1 IL2 IL3 7 6 5 4 3 2 1 0 Scandinavian German French English 19 Rank correlation Volatility of economic variables M2 Real IR IR spread FDI Unemploy GDP GDPgrowth M2/GDP CPI LT Unemploy StockTO StockValTraded IL3 IL2 IL1 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 20 Rank correlation Market Characteristics & Economic variables StockTO Listed StockValTraded Listed GDP growth CPI NewBuss M2/GDP FDI LT Unemploy GDP Corruption Real IR IR spread GINI Unemployed M2 IL3 IL2 IL1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 21 Rank correlation Legal variables Top10 TO Top10 Cap Own Conc Pub Enforce Anti Dir Prospect Liab Tax Evas ListedCo/pop MktCap/GDP Anti SelfDeal Disclosure -0.6 -0.4 -0.2 0 0.2 0.4 0.6 22 Rank correlation Deouk et. al. variables for capital market governance Volatility Syncronicity IPO return Expected Ret IL3 IL2 IL1 EarnOpac Vol/Cap US/MktCap CMG Index Cost of Equity MktDepth -0.6 -0.4 -0.2 0 0.2 0.4 0.6 23 Regional Illiquidity Measures 24 Liquidity & the 1987 Crash Amihud (1990, JPM) Period I: Oct5-Oct9, Period II: Oct19, Period III: Oct30 Pt Pt m $spreadt ln ln m 0 1 2 Pt 1 Pt 1 $spreadt 1 $spread I i $spread I Period II (t) vs. Period I (t-1) Period III (t) vs. Period II (t-1) 25 Liquidity & the 1987 Crash Amihud (1990, JPM) • Stocks that experienced a greater increase in bid-ask spread suffer a greater price decline during the crash => liquidity is a price factor • Alpha2 is insignificant during the crash (II vs. I) but significantly negative afterwards (III vs. II) => flight to quality • By the end of 1987, spread had narrowed but remained higher than before Oct => persistence 26 To Do List: • Compare CRSP-NYSE vs. NASDAC • Study spread on e.g. Korea, Malaysia vs. US • Riskmetrics’s individual company governance scores • More robust econometrics • Managing liquidity-VaR 28