Supervisor: Professor Moisa Altar MSc Student: Horatiu Lovin Bucharest 2007
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Transcript of Supervisor: Professor Moisa Altar MSc Student: Horatiu Lovin Bucharest 2007
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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turnover (monthly) (left scale) Bucharest Stock Exchange Index (right scale)
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
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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!