Showing papers on "Market liquidity published in 2007"

Market liquidity and funding liquidity

Abstract: 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

Giving Content to Investor Sentiment: The Role of Media in the Stock Market

Abstract: I quantitatively measure the interactions between the media and the stock market using daily content from a popular Wall Street Journal column. I find that high media pessimism predicts downward pressure on market prices followed by a reversion to fundamentals, and unusually high or low pessimism predicts high market trading volume. These and similar results are consistent with theoretical models of noise and liquidity traders, and are inconsistent with theories of media content as a proxy for new information about fundamental asset values, as a proxy for market volatility, or as a sideshow with no relationship to asset markets.

Market Liquidity and Funding Liquidity

Abstract: We provide a model that links a security's market liquidity - i.e., the ease of trading it - and traders' funding liquidity - i.e., their availability of funds. Traders provide market liquidity and their ability to do so depends on their funding, that is, their capital and the margins charged by their financiers. In times of crisis, reductions in market liquidity and funding liquidity are mutually reinforcing, leading to a liquidity spiral. The model explains the empirically documented features that market liquidity (i) can suddenly dry up (i.e. is fragile), (ii) has commonality across securities, (iii) is related to volatility, (iv) experiences "flight to liquidity" events, and (v) comoves with the market. Finally, the model showshow the Fed can improve current market liquidity by committing to improve funding in a potential future crisis.

Working capital management and profitability-case of pakistani firms

Abstract: Working Capital Management has its effect on liquidity as well on profitability of the firm. In this research, we have selected a sample of 94 Pakistani firms listed on Karachi Stock Exchange for a period of 6 years from 1999 – 2004, we have studied the effect of different variables of working capital management including the Average collection period, Inventory turnover in days, Average payment period, Cash conversion cycle and Current ratio on the Net operating profitability of Pakistani firms. Debt ratio, size of the firm (measured in terms of natural logarithm of sales) and financial assets to total assets ratio have been used as control variables. Pearson’s correlation, and regression analysis (Pooled least square and general least square with cross section weight models) are used for analysis. The results show that there is a strong negative relationship between variables of the working capital management and profitability of the firm. It means that as the cash conversion cycle increases it will lead to decreasing profitability of the firm, and managers can create a positive value for the shareholders by reducing the cash conversion cycle to a possible minimum level. We find that there is a significant negative relationship between liquidity and profitability. We also find that there is a positive relationship between size of the firm and its profitability. There is also a significant negative relationship between debt used by the firm and its profitability.

Liquidity and Expected Returns: Lessons From Emerging Markets

Abstract: Given the cross-sectional and temporal variation in their liquidity, emerging equity markets provide an ideal setting to examine the impact of liquidity on expected returns. Our main liquidity measure is a transformation of the proportion of zero daily firm returns, averaged over the month. We find that it significantly predicts future returns, whereas alternative measures such as turnover do not. Consistent with liquidity being a priced factor, unexpected liquidity shocks are positively correlated with contemporaneous return shocks and negatively correlated with shocks to the dividend yield. We consider a simple asset-pricing model with liquidity and the market portfolio as risk factors and transaction costs that are proportional to liquidity. The model differentiates between integrated and segmented countries and time periods. Our results suggest that local market liquidity is an important driver of expected returns in emerging markets, and that the liberalization process has not fully eliminated its impact.

Corporate Yield Spreads and Bond Liquidity

Abstract: We find that liquidity is priced in corporate yield spreads. Using a battery of liquidity measures covering over 4,000 corporate bonds and spanning both investment grade and speculative categories, we find that more illiquid bonds earn higher yield spreads, and an improvement in liquidity causes a significant reduction in yield spreads. These results hold after controlling for common bond-specific, firm-specific, and macroeconomic variables, and are robust to issuers' fixed effect and potential endogeneity bias. Our findings justify the concern in the default risk literature that neither the level nor the dynamic of yield spreads can be fully explained by default risk determinants.

Liquidity and Market Efficiency

Abstract: Market efficiency, the timely incorporation of information into prices, remains a central and controversial issue in finance. The short-horizon predictability of returns from past order flows is an inverse indicator of efficiency. We analyze this predictability for NYSE stocks that traded every day from 1993 through 2002. Mid-quote return predictability is diminished when bid-ask spreads are narrower. Such predictability has declined over time with the minimum tick size. Variance ratios of five-minute and daily returns suggest that prices were closer to random walk benchmarks during decimal regimes than during regimes with higher tick sizes (and wider spreads). These findings support the notion that liquidity stimulates arbitrage activity, which, in turn, enhances market efficiency. Further, as the tick size decreased, open-close/close-open return variance ratios increased, while return autocorrelations decreased. This suggests an increased incorporation of private information into prices during more liquid regimes.

Collective Risk Management in a Flight to Quality Episode

Abstract: We present a model of optimal intervention in a flight to quality episode. The reason for intervention stems from a collective bias in agents' expectations. Agents in the model make risk management decisions with incomplete knowledge. They understand their own shocks, but are uncertain of how correlated their shocks are with systemwide shocks, treating the latter uncertainty as Knightian. We show that when aggregate liquidity is low, an increase in uncertainty leads agents to a series of protective actions -- decreasing risk exposures, hoarding liquidity, locking-up capital -- that reflect a flight to quality. However, the conservative actions of agents leave the aggregate economy over-exposed to negative shocks. Each agent covers himself against his own worst-case scenario, but the scenario that the collective of agents are guarding against is impossible. A lender of last resort, even if less knowledgeable than private agents about individual shocks, does not suffer from this collective bias and finds that pledging intervention in extreme events is valuable. The intervention unlocks private capital markets.

Institutional Investors and the Informational Efficiency of Prices

Abstract: The percentage of U.S. equity held by institutional investors has quadrupled in the past four decades, and a prominent share of trading activity is due to institutions. Yet we know little about how institutions affect the informational efficiency of share prices, one important dimension of market quality. We study a broad cross-section of NYSE-listed stocks between 1983 and 2004 using measures of the relative informational efficiency of prices constructed from transaction data. We find that stocks with greater institutional ownership are priced more efficiently in the sense that their transaction prices more closely follow a random walk. This result cannot be attributed to liquidity effects and is not likely the result of reverse causality. We also show that institutional trading activity is one mechanism by which prices become more efficient, even when institutions trade passively or follow momentum strategies.

Trade Credit: Suppliers as Debt Collectors and Insurance Providers

Abstract: This article examines how in a context of limited enforceability of contracts suppliers may have a comparative advantage over banks in lending to customers because they are able to stop the supply of intermediate goods. Suppliers may act also as liquidity providers, insuring against liquidity shocks that could endanger the survival of their customer relationships. The relatively high implicit interest rates of trade credit are the result of insurance and default premiums that are amplified whenever suppliers face a relatively high cost of funds. I explore these effects empirically for a panel of UK firms.

Pricing the Commonality Across Alternative Measures of Liquidity

Abstract: We estimate latent factor models of liquidity, aggregated across various liquidity measures. Shocks to assets' liquidity have a common component across measures which accounts for most of the explained variation in individual liquidity measures. We find that across-measure systematic liquidity is a priced factor while within-measure systematic liquidity does not exhibit additional pricing information. Controlling for across-measure systematic liquidity risk, there is some evidence that liquidity, as a characteristic of assets, is priced in the cross-section. Our results are robust to the inclusion of other equity characteristics and risk factors, such as market capitalization, book-to-market, and momentum.

Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications

Abstract: An entrepreneur with limited liability needs to finance an infinite horizon investment project. An agency problem arises because she can divert operating cash-flows before reporting them to the financiers. We first study the optimal contract in discrete time. This contract can be implemented by cash reserves, debt and equity. The latter is split between the financiers and the entrepreneur, and pays dividends when retained earnings reach a threshold. To provide appropriate incentives to the entrepreneur, the firm is downsized when it runs short of cash. We then study the continuous-time limit of the model. We prove the convergence of the discrete-time value functions and optimal contracts. Our analysis yields rich implications for the dynamics of security prices. Stock prices follow a diusion reflected at the dividend barrier and absorbed at zero. Their volatility, as well as the leverage ratio of the firm, increase after bad performance. Stock prices and book-tomarket ratios are in a non-monotonic relationship. A more severe agency problem entails lower price earning ratios and firm liquidity, and higher default risk.

Does International Cross-Listing Improve the Information Environment?

Abstract: We investigate whether cross-listing in the U.S. affects the information environment for non-U.S. stocks. Our findings suggest cross-listing has an asymmetric impact on stock price informativeness around the world, as measured by firm-specific stock return variation. Cross-listing improves price informativeness for developed market firms. For firms in emerging markets, however, cross-listing decreases price informativeness. We also find that price informativeness increases the most for firms in countries with the greatest investor protection. The added analyst coverage associated with cross-listing likely explains the findings in emerging markets, rather than changes in liquidity, ownership, or accounting quality. Our results indicate that the added analyst coverage fosters the production of marketwide information, rather than firm-specific information.

Financial Intermediation and the Costs of Trading in an Opaque Market

Abstract: Municipal bonds trade in opaque, decentralized broker-dealer markets in which price information is costly to gather. We analyze a database of trades between broker-dealers and customers in municipal bonds. These data were only released to the public with a lag; the market was opaque. Dealers earn lower average markups on larger trades, even though dealers bear a higher risk of losses with larger trades. We estimate a bargaining model and compute measures of dealer?s bargaining power. Dealers exercise substantial market power. Our measures of market power decrease in trade size and increase in the complexity of the trade for the dealer.

Transparency and Liquidity: A Controlled Experiment on Corporate Bonds

Abstract: This article reports the results of an experiment designed to assess the impact of lastsale trade reporting on the liquidity of BBB corporate bonds Overall, adding transparency has either a neutral or a positive effect on liquidity Increased transparency is not associated with greater trading volume Except for very large trades, spreads on newly transparent bonds decline relative to bonds that experience no transparency change However, we find no effect on spreads for very infrequently traded bonds The observed decrease in transaction costs is consistent with investors’ ability to negotiate better terms of trade once they have access to broader bond-pricing data (JEL codes: G14, G18, G23, G24, G28) Although larger than the market for US Government or municipal bonds, the corporate bond market historically has been one of the least transparent securities markets in the United States, with neither pretrade nor posttrade transparency Corporate bonds trade primarily over-the-counter, and until recently, no centralized mechanism existed to collect and disseminate posttransaction information This structure changed on July 1, 2002, when the National Association of Securities Dealers (NASD) began a program of increased posttrade transparency for corporate bonds, known as the Trade Reporting and Compliance Engine (TRACE) system As part of this structural change, only a selected subset of bonds initially was subject to public dissemination of trade information The resulting experiment enables us to observe the effects of increased posttrade transparency on market liquidity in a controlled setting

Emerging Markets Spreads and Global Financial Conditions

Abstract: In this article, we analyse how much of the reduction in emerging markets spreads can be ascribed to specific factors - linked to the improvement in the 'fundamentals' of a given country - rather than to common factors - linked to global liquidity conditions and agents' degree of risk aversion. By means of factor analysis, we find that a single common factor is able to explain a large part of the co-variation in emerging market economies spreads observed in the last four years; on its turn, this common factor might be traced back mainly to financial markets volatility. Due to the particularly benign global financial conditions in recent years, spreads seem to have declined to levels lower than those warranted by improved fundamentals. As a consequence, EMEs do remain vulnerable to sudden shift in financial market conditions.

Analyst Disagreement, Mispricing, and Liquidity*

Abstract: Examining returns of stocks with high levels of analyst disagreement about future earnings reveals a close link between mispricing and liquidity. Previous research finds these stocks often to be overpriced, but prices to correct down within a fiscal year as uncertainty about earnings is resolved. We conjecture that one reason mispricing has persisted is that these stocks have higher trading costs than otherwise similar stocks, possibly because some investors are better informed than the market maker about how to aggregate analysts’ opinions. As analyst disagreement increases so does the informational disadvantage of the marker maker, and trading costs rise. In the cross-section, less liquid stocks are, on average, more severely mispriced. Moreover, increases in aggregate market liquidity accelerate convergence of prices to fundamentals. As a result, returns of initially overpriced stocks are negatively correlated with the time series of innovations in aggregate market liquidity.

Slow moving capital

Abstract: We study three cases in which specialized arbitrageurs lost significant amounts of capital and, as a result, became liquidity demanders rather than providers. The effects on security markets were large and persistent: Prices dropped relative to fundamentals and the rebound took months. While multi-strategy hedge funds who were not capital constrained increased their positions, a large fraction of these funds actually acted as net sellers consistent with the view that information barriers within a firm (not just relative to outside investors) can lead to capital constraints for trading desks with mark-to-market losses. Our findings suggest that real world frictions impede arbitrage capital.

Cash-in-The-Market Pricing and Optimal Resolution of Bank Failures

Abstract: As the number of bank failures increases, the set of assets available for acquisition by the surviving banks enlarges but the total amount of available liquidity within the surviving banks falls. This results in 'cash-in-the-market' pricing for liquidation of banking assets. At a sufficiently large number of bank failures, and in turn, at a sufficiently low level of asset prices, there are too many banks to liquidate and inefficient users of assets who are liquidity-endowed may end up owning the liquidated assets. In order to avoid this allocation inefficiency, it may be ex-post optimal for the regulator to bail out some failed banks. We show however that there exists a policy that involves liquidity assistance to surviving banks in the purchase of failed banks and that is equivalent to the bailout policy from an ex-post standpoint. Crucially, the liquidity provision policy gives banks incentives to differentiate, rather than to herd, makes aggregate banking crises less likely, and, thereby dominates the bailout policy from an ex-ante standpoint.

Adopting a Label: Heterogeneity in the Economic Consequences of IFRS Adoptions *

Abstract: This paper examines the economic consequences of voluntary IFRS adoptions around the world. In contrast to prior work, we focus on the heterogeneity in the consequences, recognizing that firms have considerable discretion in how they adopt IFRS. Some firms may simply adopt a label, while others view the decision as a serious commitment to transparency. We hypothesize that the economic consequences depend on the extent to which IFRS adoptions represent a serious commitment to transparency. Our results support this prediction. We classify firms into “label” and “serious” adopters and analyze whether capital markets respond to differences in adoption quality, using proxies for market liquidity and the cost of capital. We find that the average effects of voluntary IFRS reporting on these proxies are generally modest, especially when compared to other forms of commitment such as cross-listing in the U.S. However, consistent with our predictions, we find that “serious” adopters experience significantly stronger effects on the cost of capital and market liquidity than label adopters.

Episodic Liquidity Crises: Cooperative and Predatory Trading

Abstract: We describe how episodic illiquidity arises from a breakdown in cooperation between market participants. We first solve a one-period trading game in continuous-time, using an asset pricing equation that accounts for the price impact of trading. Then, in a multi-period framework, we describe an equilibrium in which traders cooperate most of the time through repeated interaction, providing apparent liquidity to one another. Cooperation breaks down when the stakes are high, leading to predatory trading and episodic illiquidity. Equilibrium strategies that involve cooperation across markets lead to less frequent episodic illiquidity, but cause contagion when cooperation breaks down. WHY IS ILLIQUIDITY RARE and episodic? Pastor & Stambaugh (2003) detect only 14 aggregate low-liquidity months over the time period 1962 to 1999. Despite being of significant magnitude, most of the episodes were short-lived and were followed by long periods of liquidity. 1 The origin of this empirical observation still remains a puzzle. In this paper, we attempt to shed light on this puzzle by developing a theoretical model in which a breakdown in cooperation between traders in the market manifests itself in predatory trading. This mechanism leads to sudden and short-lived illiquidity. We develop a dynamic model of trading based on liquidity needs. During each period, a liquidity event may occur in which a trader is required to liquidate a large block of an asset in a relatively short time period. This need for liquidity is observed by a tight oligopoly, whose members may choose to predate or cooperate. Predation involves racing and fading the distressed trader to the market,

The Reaction of Consumer Spending and Debt to Tax Rebates - Evidence from Consumer Credit Data

Abstract: We use a new panel dataset of credit card accounts to analyze how consumer responded to the 2001 Federal income tax rebates We estimate the monthly response of credit card payments, spending, and debt, exploiting the unique, randomized timing of the rebate disbursement We find that, on average, consumers initially saved some of the rebate, by increasing their credit card payments and thereby paying down debt But soon afterwards their spending increased, counter to the canonical Permanent-Income model Spending rose most for consumers who were initially most likely to be liquidity constrained, whereas debt declined most (so saving rose most) for unconstrained consumers More generally, the results suggest that there can be important dynamics in consumers' response to 'lumpy' increases in income like tax rebates, working in part through balance sheet (liquidity) mechanisms

Stock Market Development in Sub-Saharan Africa: Critical Issues and Challenges

Abstract: This paper examines the economic importance of stock markets in Africa. It discusses policy options for promoting the development of the stock market in Africa. The results of the paper show that the stock markets have contributed to the financing of the growth of large corporations in certain African countries. An econometric investigation of the impact of stock markets on growth in selected African countries, however, finds inconclusive evidence even though stock market value traded seem to be positively and significantly associated with growth. African stock exchanges now face the challenge of integration and need better technical and institutional development to address the problem of low liquidity. Preconditions for successful regional approaches include the harmonization of legislations such as bankruptcy and accounting laws and a liberalized trade regime. Robust electronic trading systems and central depository systems will be important. Further domestic financial liberalization such as steps to improve the legal and accounting framework, private sector credit evaluation capabilities, and public sector regulatory oversight would also be beneficial.

Is there a Difference? The Performance Characteristics of SRI Equity Indexes

Abstract: Investments in socially responsible investments (SRI) are still a small, but growing segment of international capital markets. This study analyses whether a SRI screening process applied to equities results in a different performance outcome compared to relevant conventional benchmark indexes. In contrast to other studies, the analysis concentrates on SRI indexes and not on investment funds. This has several advantages, which include that the transaction costs of funds, the timing activities and the skill of the fund management do not have to be considered. This leads to a relatively direct measure of the performance effects of SRI screens. The 29 SRI stock indexes are analysed by single-factor models with benchmarks that closely approximate the investment universe of the SRI stock indexes and by multi-equation systems that also exploit the information in the cross-section. The results show that SRI stock indexes do not exhibit a different risk-adjusted return than conventional benchmarks. But many SRI indexes have a higher risk relative to the benchmarks. These findings are robust to the use of different sets of benchmark indexes and apply to all common types of SRI screening.