Doctoral School of Finance and Banking

Liquidity indicator and liquidity risk

pricing for Bucharest Stock Exchange

Supervisor: Professor Moisa AltarMSc Student: Horatiu Lovin

Bucharest 2007

“Liquidity, according to Keynes, offers a classic example of the

fallacy of composition: what is true for a part is not necessarily true for the whole. The ability to reverse positions and get out quickly vanishes when everyone tries to do it at once.”

Merton Miller(1991)

“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

“...there is also broad belief among users of financial liquidity—traders, investors and central bankers—that the principal challenge is not the average level of financial liquidity... but its variability and uncertainty....”

Persaud (2003)

Outline

Motivation of the Study Market Liquidity Indicator Is Liquidity Risk Priced? Conclusions Main References

Motivation of the Study

Liquidity risk has increased substantially in the last decades (see Black Monday in 1987, Asian Slump in 1997 and LTCM hedge-fund collapse in 1998)

Liquidity can suddenly become a problem and even a systemic risk

Integration of domestic stock market into international financial market increased and so do contagion risk

Liquidity can be driven by psychological factors (e.g. herd behavior) and information asymmetry

Market liquidity can be a sentiment indicator if short-selling is not allowed

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Motivation of the Study

Market Liquidity Indicator The model was developed by Stambaugh and Pastor (2003)

tditdietdititdititi

etdi vrsignrr ,1,,,,,,,,,,,1, ).( (1)

Hypothesis:

Liquidity indicator is estimated monthly because order flows induce price volatility for a short period of time

If stock prices go down and volume transactions are high, returns are going to reverse stronger, so in the next period of time prices will increase higher than previous decrease

Information asymmetry can explains the trading volume impact on the relation between current and one lagged returns

Liquidity risk increase during stress periods, when stock prices go down and is not very significant when the market is calm

Market Liquidity Indicator

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Russian Financial Crisis and Kosovo War

World Wide Stock Markets Correction

Low Activity During Holiday

Market Liquidity Indicator

What happens if “expected” component is extracted from model?

tditditdititditititdi vrsignrr ,1,,,,,,,,,,,1, ).( (2)

Why…..?

It is possible that stock market return be affected by high level of capital concentration. In the first years of stock market activity, a high number of big companies, most of them owned by government, were listed, but poorly traded because of their weak economic performances.

Market Liquidity Indicator

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Market Liquidity Indicator

Which model do we prefer?

Model (1) – is more accurate in capturing liquidity slumps; better isolate individual component of liquidity; correlation with market returns during low liquidity months

is 0.196756; average residuals correlation across stocks is 0.297445;

Model (2) – doesn’t fit very well liquidity breakdowns; correlation with market returns during low liquidity months

is 0.278107; average residuals correlation across stocks is 0.41335.

Market Liquidity Indicator

“Flight to Quality” effect

Correlations between stock index returns and:

Rf Volume Number of observations

All months -0.10438 0.257562 100

Low liquidity months -0.19914 0.729308 11

Other months 0.196432 0.207692 89

Stock market returns and trading volume decrease when liquidity is low, but government bonds yield goes up

Is liquidity risk priced?

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We investigate wheather a stock’s expected return is related to the sensitivity of its return to agregate liquidity indicator,

Li -Explains a component of expected return which is

not captured by exposures to market risk (factors of Fama and French (1993))

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Is liquidity risk priced?

Is liquidity risk priced?

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Normal Kernel Distribution for Liquidity Indicator

Normal Kernel Distribution for Liquidity Betas

Portfolios

1 2 3 4 5

Intercept -0.012601 -0.072524 -0.02074 -0.02657 0.007235

(-2.152198) (-8.937709) (-4.372999) (-7.157692) (1.966914)

Liquidity -10.26819 -3.675009 -3.600107 -1.747587 6.845152

(-10.24285) (-4.007436) (-5.477937) (-3.905028) (8.848262)

MKT -0.422357 0.787796 0.614394 0.141169 0.278051

(-1.719068) (3.285125) (3.733376) (1.08733) (1.298342)

SMB 0.676733 -0.758127 -0.319692 -0.310417 -0.74027

(4.15847) (-4.875519) (-2.947155) (-3.162903) (-5.834939)

HML -0.700785 0.415322 0.061239 0.576517 0.369325

(-3.40451) (2.005212) (0.486809) (5.66719) (2.316566)

Estimation results for stocks sorted by liquidity sensitivity into 5 portfolios

Is liquidity risk priced?

Conclusions

The model of Stambaugh and Pastor (2003) brings out realistic results for Bucharest Stock Exchange

Market liquidity appears to be an important variable for pricing stocks

Liquidity indicator capture the dimension associated with the strenght of volume related return reversal

Investors moves from stock market to bond market when stock liquidity is low

Low capitalized stocks with persistently high earnings have a higher sensitivity to market liquidity (an explanation can be high concentration of market capitalization)

Next steps….

Quantification of liquidity risk premiums Modeling liquidity with another model in

order to test robustness of our results Deepening research on extreme liquidity

events

Main references Kyle, A.(1985), “Continuous Auctions and Insider Trading”, Econometrica, 53, 1315 -

1335 Campbell, J.Y., S.J. Grossman and J. Wang (1993), “Trading volume and Serial

Correlation in Stock Returns”, The Quarterly Journal of Economics, 108, 905 – 939 Campbell, J.Y., W.Lo Andrew, A.C. MacKinlay and Y.Lo Andrew (1996), “The

Econometrics of Financial Markets”, Princeton University Press Fama, E.F. and K.R. French (1996), “Multifactor Explanations of Asset Pricing

Anomalies”, The Journal of Finance, 51, 55 – 84 Chordia, T., R. Roll and A. Subrahmanyam (2001), “Market Liquidity and Trading

Activity”, The Journal of Finance, 56, 501 – 530 Baker, M. and J.C. Stein (2002), “Market Liquidity as a Sentiment Indicator”, Harvard

Institute of Economic Research Gibson, R. and N. Mougeot (2002), “The pricing of systematic liquidity risk: Empirical

evidence from the US stock market”, Journal of Banking & Finance, 28, 157 – 178 Malz, A.M. (2003), “Liquidity Risk: Current Research and Practice”, Risk Metrics

Journal Pastor, L. and R.F. Stambaugh (2003), “Liquidity Risk and Expected Stock Returns”,

The Journal of Political Economy, 111, 642 - 685 Wagner, N. and T.A. Marsh (2004), “Surprise Volume and Heteroskedasticity in

Equity Market Returns”, available at SSRN: http://ssrn.com/abstract=591206 Acharya, V. and L.H. Pedersen (2005), “Asset pricing with liquidity risk”, Journal of

Financial Economics, 77, 375 – 410 Huddart, S., M. Lang and M.H. Yetman (2006), “Psychological Factors, Stock Price

Path, and Trading Volume”, available at SSRN: http://ssrn.com/abstract=353749

Thank you!