Liquidity: Earlier Developments & Liquidity Risk

Question 1

Amihud and Mendelson 1986

Answer 1

• studies the effect of the bid-ask spread on asset pricing.
• analyze a model in which investors with different expected holding periods trade assets with different relative spreads.
• resulting testable hypothesis is that market-observed expected return is an increasing and concave function of the spread.
• empirical results are consistent with the predictions of the model.

Question 2

Brennan and Subrahmanyam 1996

Answer 2

• Adverse selection creates illiquidity costs for uninformed investors ⇒ ROR should be higher for relatively illiquid securities
• investigate the empirical relation between monthly stock returns and measures of illiquidity obtained from intraday data.
• find a significant relation between required rates of return and these measures after adjusting for the Fama and French risk factors and also after accounting for the effects of the stock price level.

Question 3

Amihud 2002

Answer 3

• over time, expected market illiquidity (+) affects ex ante Ri - Rf, suggesting that E[Ri - Rf] partly represents an illiquidity premium.
• complements the cross-sectional (+) return-illiq relationship.
• stock returns neg related over time to contemporaneous unexpected illiquidity.
• ILLIQ is the avg across stocks of the daily ratio of absolute stock return to dollar volume
• Illiquidity affects more strongly small firm stocks, thus explaining time series variations in their premiums over time.

Question 4

Pastor and Stambaugh 2003

Answer 4

• find expected returns are related cross-sectionally to the sensitivities to fluctuations in aggregate liq
• mo liq measure relies on the principle that order flow induces greater return reversals when liquidity is lower.
• From 1966-1999, the avg return on stocks with high sensitivities to liq exceeds that for stocks with low by 7.5% annualy, adjusted for exposures to the market return as well as size, value, and momentum factors.
• liq risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.

Question 5

Acharya Pedersn 2005

Answer 5

• Model Setup: OLG, risk-averse agents, constant absolute risk aversion, exponential utility Model
• Results: liquidity-adjusted CAPM; comprised of a “net beta” decomposed into market beta and three liquidity risk betas:
• (1) commonality in i’s liq with mkt liq cov(Ci, Cm) (2) Ri sensitivity to mkt liq cov(Ri, Cm) (3) i’s liq sensitivity to Rm
• Empirical Findings: (1) cov(Ci,Cm) risk premium of 0.08% (2) cov(Ri,Cm) 0.16% (3) cov(Ci, Rm) 0.82% Can’t explain book-to-market effect

Question 6

Liu 2006

Answer 6

• Motivation: prior studies have’nt addressed all aspect of liquidity simultaneously; trading quantity, trading speed, trading cost, and price impact.
• Method/Result: (1) develops a liquidity measure: standardized turnover-adjusted number of zero daily trading volumes over prior 12 months –> least liquid decile - most liquid = 0.7% per month
• (2) creates two-factor augmented CAPM: market + LIQ (buy low-liq pf, sell high-liq) –> highly neg corr with market
• (3) tests two-factor CAPM against anomalies –> describes liquidity premium & subsumes size, B/M, CF-Price, E/P, div yld, and LT contrarian.

Question 7

Bekaert Harvey Lundblad 2007

Answer 7

• An international study of liquidity in emerging markets.
• Using a liquidity measure based on zero daily returns (similar to Liu’s (2006)) measure, find that it predicts aggregate stock returns.
• Find that unexpected liq shocks correlated with contermporaneous return shocks and neg corr with shocks to div yld.
• Construct 2 factor model, liq + Rm, which differentiates integrated and segmented (markets) countries and time periods.
• Results suggest mkt liq driver of E[r] and that mkt liberalization hasn’t yet eliminated its impact.

Question 8

Liu 2010

Answer 8

• LM12 maintains it ability to predict returns in the pre-1963 data.
• Finds the liquidity risk premium is as strong in the pre-63 as in the post, and is the most significant and persistent premium in comparison to size, value and momemtum.
• In pre-1963 finds that liquidty drops at periods where it would be expected to: Great Depression and WWII.
• Extends LCAPM (LIQ + Rm) to pre-1963 data.
• Finds it still outperforms CAPM and FF3F in explaining E[r].

Question 9

Lee 2011

Answer 9

• empirically tests LCAPM of Archarya and Pedersen (2005) on a global level.
• Consistent with the model, I find evidence that liquidity risks are priced independently of market risk in intnl financial markets.
• That is, a security’s required rate of return depends on the covariance of its own liquidity with aggregate local market liquidity, as well as the covariance of its own liquidity with local and global market returns.
• show that US market is an important driving force of global liquidity risk.
• find that the pricing of liquidity risk varies across countries according to geographic, economic, and political environments.