The Divergence of Liquidity
Commonality
in the Cross-Section of Stocks
Avi Kamara
University of Washington
Xiaoxia Lou
University of Delaware
Ronnie Sadka
University of Washington
(visiting University of Chicago/GSB)
Q-Group Spring Seminar 2008
The Divergence of Liquidity
1
Literature Overview
How can liquidity affect asset prices?
¾ Transaction costs and profitability
¾ Return premium for holding illiquid
securities
¾ Aggregate liquidity as a risk factor
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Motivation and Focus
¾ Commonality in liquidity
¾ Why is it there?
¾ Does commonality change over
time? Do we expect a time trend?
Would it differ across firms?
¾ What are the implications for asset
pricing and asset management?
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Outline and Main Findings
¾ Time trend in liquidity commonality during 1963-2005
ƒ The cross-sectional variation has increased
– Large firms versus small firms
¾ The trend can be explained by institutional ownership
ƒ Cross-section
ƒ Time series
¾ Relation to return commonality
¾ Implications for diversification of return and liquidity risks
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Measure of Liquidity
and Empirical Framework
¾ Measure of liquidity:
Δ ILLIQ i ,d
⎡ ri ,d
ri ,d −1 ⎤
⎥
/
= log ⎢
⎢⎣ dvoli ,d dvoli ,d −1 ⎥⎦
¾ Measuring commonality
Δ ILLIQ i ,d = a + βi Δ ILLIQ m ,d + εi ,d
¾ Data
ƒ NYSE/AMEX stocks for 1963-2005
ƒ $2 minimum price, 100 valid observations per year
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Market Liquidity Variations
Figure 1a
¾ Spikes correspond to recognizable events
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The Divergence of Liquidity
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Volatility of Market Liquidity
Figure 1b
¾ The volatility of market liquidity has not decreased over time
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The Divergence of Liquidity
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Liquidity Commonality
of Large and Small firms
Figure 2a
¾ Large firms have become more liquidity common;
small firms less liquidity common
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Commonality Spread
Figure 2b
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Time-Trend Tests
Table 2b
¾ Stochastic time-trend tests reject unit-root process
¾ Deterministic time-trend tests show different patterns
across size groups
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Liquidity Commonality and
Institutional Ownership
Table 3
¾ Liquidity commonality increases with institutional ownership
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The Divergence of Liquidity
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Divergence of Systematic Liquidity and
Institutional Ownership
Table 4
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The Divergence of Liquidity
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Liquidity Commonality and Index Firms
Figure 4
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The Divergence of Liquidity
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What are the implications?
¾ How about stock returns?
ƒ Common aggregate determinants of liquidity beta
and return beta (Table 5)
ƒ Systematic versus idiosyncratic risk
¾ Diversification of risk and liquidity
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Systematic Liquidity and Systematic Risk
Table 6
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Implications for Diversification
Figure 5
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Robustness to Firm Age and Size
Figure 4
Q-Group Spring Seminar 2008
The Divergence of Liquidity
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Systematic Component Measured by R2
Table 7
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Robustness Tests
¾ Divergence of liquidity commonality during
extreme liquidity days
(Figure 3)
¾ Different market models
(Figure 6)
¾ Industry effects
(Table 8)
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The Divergence of Liquidity
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Summary and Conclusions
¾ The divergence of liquidity commonality has
increased over time
Large firms’ liquidity is more systematic;
small firms’ is less systematic
¾ The divergence can be explained by trends in
institutional ownership
¾ Similar divergence is found in stock returns
¾ Implications for diversification: US market is
more fragile to unanticipated liquidity events
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The Divergence of Liquidity
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