This study investigates whether marketwide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.

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Liquidity Risk and Expected Stock Returns

We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features 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) comoves with the market, and it provides new testable predictions. Keywords: Liquidity Risk Management, Liquidity, Liquidation, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Counterparty Credit Risk

Market liquidity and funding liquidity

In a financial system in which balance sheets are continuously marked to market, asset price changes appear immediately as changes in net worth, eliciting responses from financial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in dealer repos—the primary margin of adjustment for the aggregate balance sheets of intermediaries—forecast changes in financial market risk as measured by the innovations in the Chicago Board Options Exchange Volatility Index (VIX). Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.

Liquidity and Leverage

Size, Value, and Momentum in International Stock Returns §

Discount-rate variation is the central organizing question of current asset-pricing research. I survey facts, theories, and applications. Previously, we thought returns were unpredictable, with variation in price-dividend ratios due to variation in expected cashflows. Now it seems all price-dividend variation corresponds to discount-rate variation. We also thought that the cross-section of expected returns came from the CAPM. Now we have a zoo of new factors. I categorize discount-rate theories based on central ingredients and data sources. Incorporating discount-rate variation affects finance applications, including portfolio theory, accounting, cost of capital, capital structure, compensation, and macroeconomics.

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Presidential Address: Discount Rates

This paper solves explicitly a simple equilibrium model with liquidity risk. In our liquidityadjusted capital asset pricing model, a security s required return depends on its expected liquidity as well as on the covariances of its own return and liquidity with the market return and liquidity. 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 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. r 2005 Elsevier B.V. All rights reserved.

Market Liquidity: Asset Pricing with Liquidity Risk

A stock index futures contract is a standardized agreement to buy (on the long side of the contract) or sell (on the short side) a specified portfolio of stocks at a specified deferred date. The transaction is mandatory, and its detailed terms are established by the futures exchange where the contract is traded. The stock index futures contract is a derivative security, meaning that its value is a function of the value of another security (or portfolio of securities), the index. Although investors could invest directly in the stock portfolio which constitutes the index, stock index futures are viable due to their trading and liquidity advantages, which account for the outstanding growth in their trading volume in the last decade (see Figlewski (1987)). While one would expect the returns on the stock index and its derivative security, the stock-index futures contract, to exhibit exactly the same behavior, they in fact do not. The differences in the behavior patterns of these returns is the subject of this paper. A number of recent papers studied the price behavior of stock indices and stock index futures. Edwards (1987), Ng (1987), Junkus (1986), and MacKinlay and Ramaswamy (1988) found systematic differences between the price behavior of stock-index futures and the corresponding index. In this paper, we present a model of price-adjustment which explains these differences. We generalize the price-adjustment model in Amihud and Mendelson (1987) to the multi-security case, derive the variance and serial autocovariance of stock-index returns, compare them to those of the corresponding index futures, and test the predictions of the model. We also show that the positive autocorrelations of stock index-returns, which are higher and often opposite in sign compared to those of individual stocks, can be explained by our model. ' In what follows, we derive a price-adjustment model for a stock portfolio and for the corresponding futures contract. We compare the return behavior of the index and the index-futures and analyze the data presented in Mac-

Index and Index-Futures Returns:

European financial integration: How (not) to integrate the European capital markets

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Haim Mendelson

Papers

Market Liquidity: Asset Pricing with Liquidity Risk

Index and Index-Futures Returns:

European financial integration: How (not) to integrate the European capital markets

Market Liquidity: Market Microstructure and Securities Values: Evidence from the Tel Aviv Stock Exchange

Market Liquidity: Asset Pricing and the Bid–Ask Spread