Fernando-Commonality In Liquidity-Transmission Of Liquidity Shocks Across Investors And Securities.pdf

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Institutions

Center

Commonality in Liquidity: Transmission

of Liquidity Shocks across Investors and

Securities

Chitru S. Fernando

02-43

The Wharton Financial Institutions Center

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Commonality in Liquidity:

Transmission of Liquidity Shocks across Investors and Securities *

Chitru S. Fernando

Michael F. Price College of Business

University of Oklahoma

November 2002

Keywords: Market liquidity; liquidity shocks; commonality; liquidity trading.

JEL classification: G12, G14, G18, G21

* Please address correspondence to: Chitru S. Fernando, Michael F. Price College of Business,

University of Oklahoma, 307 West Brooks, Room 205, Norman, OK 73019. Tel. (405) 325-

2906; Fax: (405) 325-7688; E-mail: cfernando@ou.edu. I thank Franklin Allen, Sanford

Grossman, Bruce Grundy, Richard Herring, Richard Kihlstrom, Paul Kleindorfer, Scott Linn,

Ananth Madhavan, Venky Panchapagesan, Tony Santomero, Paul Spindt, Avanidhar

Subrahmanyam, Sam Thomas, Raman Uppal, Ernst-Ludwig von Thadden, seminar participants

at Tulane University and the 2002 Western Finance Association meetings, and two anonymous

referees for comments that helped to substantially improve this paper. I am responsible for all

errors.

Commonality in Liquidity:

Transmission of Liquidity Shocks across Investors and Securities

Abstract

Recent findings of common factors in liquidity raise many issues pertaining to the determinants

of commonality and its impact on asset prices. We explore some of these issues using a model of

liquidity trading in which liquidity shocks are decomposed into common (systematic) and

idiosyncratic components. We show that common liquidity shocks do not give rise to

commonality in trading volume, raising questions about the sources of commonality that is

detected in the literature. Indeed, trading volume is independent of systematic liquidity risk,

which is always priced independently of the liquidity in the secondary market. In contrast,

idiosyncratic liquidity shocks create liquidity demand and volume, and investors can diversify

their risk by trading. Hence, the pricing of the risk of idiosyncratic liquidity shocks depends on

the market’s liquidity, with idiosyncratic liquidity risk being fully priced only in perfectly

illiquid markets. While trading volume is increasing in the variance of idiosyncratic liquidity

shocks, price volatility is increasing in the variance of both systematic liquidity shocks and

idiosyncratic liquidity shocks. Surprisingly, our results are largely independent of the number of

different securities traded in the market. When asset returns are uncorrelated, there is no

transmission of liquidity across assets even when investors experience common (systematic)

liquidity shocks, suggesting that such liquidity shocks may not be the source of commonality in

liquidity across assets detected in the literature. However, under limited conditions, more liquid

securities can act as substitutes for less liquid securities. Overall, our findings suggest that

common factors in liquidity may be the outcome of covariation in investor heterogeneity (e.g. as

measured by co-movements in the volatility of idiosyncratic liquidity shocks) rather than of

common liquidity shocks. Moreover, we find that different liquidity proxies measure different

things, which has implications for future empirical analysis.

1. INTRODUCTION

With the proliferation of financial securities and the markets in which they trade,

considerable attention has been focused on the role of liquidity in financial markets. While the

traditional focus of research in this area has been on the liquidity of individual securities, recent

studies have detected common factors in prices, trading volume, and transactions-cost measures

such as bid-ask spreads. 1 These findings highlight the importance of understanding the

mechanics by which liquidity demand and supply is transmitted across investors and securities.

Chordia, Roll and Subrahmanyam (2000) note that drivers of common factors in liquidity may be

related to market crashes and other market incidents, pointing to recent incidents such as the

Summer 1998 collapse of the global bond market and the October 1987 stock market collapse

which did not seem to be accompanied by any significant news. They also identify as an

important area of future research the question of whether and to what extent common factors in

liquidity affect asset prices.

This paper develops a model aimed at exploring some of the issues pertaining to the

determinants of commonality and its impact on asset prices. Our model follows the basic

intuition provided by Karpoff (1986), who characterizes non-informational trading as the

outcome of differences in personal valuation of assets by investors, due to their differential

liquidity needs. In our model, liquidity shocks which cause investors to revise their personal

valuations can have both systematic (i.e. common across all investors) and idiosyncratic

components. This formulation permits us to examine the transmission of liquidity shocks across

1 See, for example, Tkac (1999), Chordia, Roll and Subrahmanyam (2000), Gibson and Mougeot (2000), Lo and

Wang (2000), Huberman and Halka (2001), and Hasbrouck and Seppi (2001).

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