Chordia, Sarkar And Subrahmanyam -An Empirical Analysis Of Stock And Bond Market Liquidity.pdf

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An E mpir ical Analysis of Stock and B ond M ar ket Liquidity

Ta r u n Ch o r d ia , ¤ A s a n i S a r ka r , ¤¤ a n d A va n id h a r S u b r a h m a n ya m

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¤ Go iz u e t a B u s in e s s S c h o o l, E m o r y U n ive r s it y.

¤¤ Fe d e r a l R e s e r ve B a n k o f N e w Y o r k.

¤¤¤ A n d e r s o n Gr a d u a t e S c h o o l o f Ma n a g e m e n t , U n ive r s it y o f Ca lifo r n ia a t L o s A n g e le s .

W e t h a n k Mic h a e l B r e n n a n , A r t u r o E s t r e lla , Mic h a e l Fle m in g , Clift o n Gr e e n , E r ic H u g h -

s o n , S t a vr o s P e r is t ia n i, R a g h u R a ja n , R e n ¶e S t u lz , a n d R o s s V a lka n o v fo r h e lp fu l c o m -

m e n t s a n d / o r fo r e n c o u r a g in g u s t o e xp lo r e t h e s e is s u e s . W e a ls o t h a n k Mic h a e l E m m e t

fo r e xc e lle n t r e s e a r c h a s s is t a n c e . Th e vie ws h e r e a r e t h o s e o f t h e a u t h o r s a n d d o n o t

n e c e s s a r ily r e ° e c t t h e vie ws o f t h e Fe d e r a l R e s e r ve B a n k o f N e w Y o r k o r t h e Fe d e r a l

R e s e r ve S ys t e m . A n y e r r o r s a r e t h e a u t h o r s ' a lo n e .

A b s t r a c t

An E mpir ical Analysis of Stock and B ond M ar ket Liquidity

W e s t u d y t h e jo in t t im e -s e r ie s o f d a ily liqu id it y in b o n d a n d s t o c k m a r ke t s o ve r t h e

p e r io d , 1 9 9 1 t o 1 9 9 8 . W e ¯ n d t h a t s p r e a d s a n d d e p t h s in t h e s t o c k a n d b o n d m a r ke t s

a r e p r e d ic t a b le u s in g la g g e d s p r e a d s a n d la g g e d o r d e r im b a la n c e s . U n e xp e c t e d liqu id it y

s h o c ks a r e p o s it ive ly a n d s ig n i¯ c a n t ly c o r r e la t e d a c r o s s s t o c k a n d b o n d m a r ke t s , s u g -

g e s t in g t h a t liqu id it y s h o r t a g e s a n d r e p le n is h m e n t s a r e o ft e n s ys t e m ic in n a t u r e . D u r in g

p e r io d s o f ¯ n a n c ia l c r is e s , t h e c o r r e la t io n in s t o c k a n d b o n d s p r e a d in n o va t io n s in c r e a s e s .

Mo n e t a r y p o lic y a p p e a r s t o h a ve a n a m e lio r a t ive e ®e c t o n s t o c k m a r ke t liqu id it y d u r -

in g c r is e s . U .S . g o ve r n m e n t b o n d fu n d s s e e h ig h e r in ° o ws a n d e qu it y fu n d s s e e h ig h e r

o u t ° o ws d u r in g ¯ n a n c ia l c r is e s , s u g g e s t in g a ° ig h t t o qu a lit y d u r in g p e r io d s o f s t r e s s .

JE L COD E S : G1 0 , G1 4 , G2 3 , E 5 2

1 I ntr oduction

A n u m b e r o f im p o r t a n t t h e o r e m s in ¯ n a n c e r e ly o n t h e a b ilit y o f in ve s t o r s t o t r a d e a n y

a m o u n t o f a s e c u r it y wit h o u t a ®e c t in g t h e p r ic e . H o we ve r , t h e r e e xis t s e ve r a l fr ic t io n s , 1

s u c h a s t r a d in g c o s t s , s h o r t s a le r e s t r ic t io n s , c ir c u it b r e a ke r s , e t c . t h a t im p a c t p r ic e

fo r m a t io n . Th e in ° u e n c e o f m a r ke t im p e r fe c t io n s o n s e c u r it y p r ic in g h a s lo n g b e e n r e c -

o g n iz e d . L iqu id it y, in p a r t ic u la r , h a s a t t r a c t e d a lo t o f a t t e n t io n fr o m t r a d e r s , r e g u la t o r s ,

e xc h a n g e o ± c ia ls a s we ll a s a c a d e m ic s .

L iqu id it y, a fu n d a m e n t a l c o n c e p t in ¯ n a n c e , c a n b e d e ¯ n e d a s t h e a b ilit y t o b u y o r s e ll

la r g e qu a n t it ie s o f a n a s s e t qu ic kly a n d a t lo w c o s t . Th e va s t m a jo r it y o f e qu ilib r iu m a s s e t

p r ic in g m o d e ls d o n o t c o n s id e r t r a d in g a n d t h u s ig n o r e t h e t im e a n d c o s t o f t r a n s fo r m in g

c a s h in t o ¯ n a n c ia l a s s e t s o r vic e ve r s a . R e c e n t ¯ n a n c ia l c r is e s , h o we ve r , s u g g e s t t h a t ,

a t t im e s , m a r ke t c o n d it io n s c a n b e s e ve r e a n d liqu id it y c a n d e c lin e o r e ve n d is a p p e a r . 2

S u c h liqu id it y s h o c ks a r e a p o t e n t ia l c h a n n e l t h r o u g h wh ic h a s s e t p r ic e s a r e in ° u e n c e d

b y liqu id it y. A m ih u d a n d Me n d e ls o n ( 1 9 8 6 ) a n d Ja c o b y, Fo wle r , a n d Go t t e s m a n ( 2 0 0 0 )

p r o vid e t h e o r e t ic a l a r g u m e n t s t o s h o w h o w liqu id it y im p a c t s ¯ n a n c ia l m a r ke t p r ic e s . 3

U n t il r e c e n t ly, s t u d ie s o n liqu id it y we r e fo c u s e d p r in c ip a lly o n it s c r o s s -s e c t io n a l d e -

t e r m in a n t s , a n d we r e r e s t r ic t e d t o e qu it y m a r ke t s ( e .g ., B e n s t o n a n d H a g e r m a n , 1 9 7 4 ,

a n d S t o ll, 1 9 7 8 ) . A s m o r e d a t a h a s b e c o m e a va ila b le , r e c e n t wo r k h a s s h ift e d fo c u s o n

s t u d yin g t im e -s e r ie s p r o p e r t ie s o f liqu id it y in e qu it y m a r ke t s a s we ll a s in ¯ xe d -in c o m e

m a r ke t s . H a s b r o u c k a n d S e p p i ( 2 0 0 1 ) , H u b e r m a n a n d H a lka ( 2 0 0 1 ) , a n d Ch o r d ia , R o ll

a n d S u b r a h m a n ya m ( 2 0 0 0 ) d o c u m e n t c o m m o n a lit y in e qu it y m a r ke t liqu id it y b y s h o w-

1 See Stoll (2000).

2 \One after another, LTCM's partners, calling in from Tokyo and London, reported that their markets

had dried up. There were no buyers, no sellers. It was all but impossible to maneuver out of large trading

bets." { Wall Street Journal , November 16, 1998.

3 See also Brennan and Subrahmanyam (1996) and Brennan, Chordia and Subrahmanyam (1998).

in g t h a t s p r e a d s a n d d e p t h s o f in d ivid u a l s t o c ks c o -m o ve wit h m a r ke t - a n d in d u s t r y-wid e

liqu id it y. Ch o r d ia , R o ll, a n d S u b r a h m a n ya m ( 2 0 0 1 ) s t u d y d a ily a g g r e g a t e e qu it y m a r ke t

s p r e a d s , d e p t h s a n d t r a d in g a c t ivit y o ve r a n e xt e n d e d p e r io d t o d o c u m e n t we e kly r e g u -

la r it ie s in liqu id it y a n d t h e in ° u e n c e o f m a r ke t r e t u r n s , vo la t ilit y a n d in t e r e s t r a t e s o n

liqu id it y, wh ile Jo n e s ( 2 0 0 1 ) s t u d ie s a n n u a l e qu it y liqu id it y o ve r m o r e t h a n 1 0 0 ye a r s .

Fle m in g ( 1 9 9 7 , 2 0 0 1 ) , a n d B r a n d t , E d e le n , a n d K a va je c z ( 2 0 0 1 ) s t u d y liqu id it y in t h e

U S g o ve r n m e n t b o n d m a r ke t wh ile Fle m in g a n d R e m o lo n a ( 1 9 9 7 , 1 9 9 9 ) , B a ld u c c i, E lt o n

a n d Gr e e n ( 2 0 0 1 ) a n a lyz e r e t u r n s , s p r e a d s , a n d t r a d in g vo lu m e in b o n d m a r ke t s a r o u n d

e c o n o m ic a n n o u n c e m e n t s .

S o fa r t h e lit e r a t u r e o n s t o c k a n d b o n d liqu id it ie s h a s d e ve lo p e d in s e p a r a t e s t r a n d s .

In p r a c t ic e , h o we ve r , a n u m b e r o f a s s e t a llo c a t io n s t r a t e g ie s s h ift we a lt h b e t we e n s t o c k

a n d b o n d m a r ke t s . 4

Th e qu e s t io n n a t u r a lly a r is e s a s t o t h e o p t im a l wa y o f e xe c u t in g

t h e s e s t r a t e g ie s s o a s t o m in im iz e t r a d in g c o s t s . In p a r t ic u la r , it is o f in t e r e s t t o c o n -

s id e r wh e t h e r t im in g t h e s e a llo c a t io n s o r s e qu e n c in g t h e m in a p a r t ic u la r wa y c a n r e d u c e

t r a d in g c o s t s a s s o c ia t e d wit h t h e s e s t r a t e g ie s . Fo r e xa m p le , if t h e n a t u r e o f c a le n d a r r e g -

u la r it ie s a c r o s s s t o c k a n d b o n d m a r ke t s is d i®e r e n t , t h e n s t a g g e r in g a llo c a t io n s t r a t e g ie s

m a y le a d t o lo we r t r a d in g c o s t s . A d d r e s s in g t h is is s u e r e qu ir e s t h e a n a lys is o f t h e jo in t

t im e -s e r ie s o f s t o c k a n d b o n d liqu id it y, a n d in p a r t ic u la r , t h e qu e s t io n o f wh e t h e r t h e s e

s e r ie s h a ve c o m m o n d e t e r m in a n t s a s s u m e s im p o r t a n c e .

Mo t iva t e d in p a r t b y t h e a b o ve o b s e r va t io n , in t h is p a p e r , we jo in t ly s t u d y t h e t im e -

s e r ie s o f liqu id it y in s t o c k a n d t h e U .S . Go ve r n m e n t b o n d m a r ke t s . S t o c ks a n d b o n d s a r e

im p o r t a n t fo r r e s o u r c e a llo c a t io n , a s t h e y a r e t h e m a in ve h ic le s b y wh ic h fu n d s a r e r a is e d

fo r lo n g -t e r m in ve s t m e n t s b y ¯ r m s a n d g o ve r n m e n t s . S in c e liqu id it y h a s b e e n s h o wn t o

4 See, for example, Amman and Zimmerman (2001) and Fox (1999) for practical considerations, and

Barberis (2000) or Xia (2001) for more academic studies.

b e r e la t e d t o a s s e t r e t u r n s a n d , in t u r n , c o s t s o f c a p it a l, a n a lyz in g h o w s t o c k a n d b o n d

liqu id it ie s m o ve a n d c o -m o ve o ve r t im e is a ls o im p o r t a n t fo r e n h a n c in g t h e e ± c a c y o f

r e s o u r c e a llo c a t io n .

Ou r c o n s id e r a t io n o f t h e jo in t t im e -s e r ie s o f s t o c k a n d b o n d m a r ke t liqu id it y s h e d s

lig h t o n s p e c i¯ c r e s e a r c h qu e s t io n s t h a t h a ve n o t ye t b e e n a d d r e s s e d in t h e lit e r a t u r e :

² W h a t is t h e e xt e n t o f c o -m o ve m e n t b e t we e n s t o c k a n d b o n d liqu id it y a n d h o w d o e s

t h e n a t u r e o f t h is c o -m o ve m e n t c h a n g e d u r in g ¯ n a n c ia l c r is e s ?

² A r e t h e r e s p illo ve r e ®e c t s fr o m b o n d liqu id it y t o s t o c k liqu id it y o r vic e ve r s a ?

² Is ¯ n a n c ia l m a r ke t liqu id it y p r e d ic t a b le u s in g p u b lic ly a va ila b le in fo r m a t io n ? If s o ,

wh a t va r ia b le s h e lp fo r e c a s t fu t u r e s t o c k a n d b o n d m a r ke t liqu id it y?

² W h a t a r e t h e t im e -s e r ie s p r o p e r t ie s o f u n e xp e c t e d liqu id it y s h o c ks ? A r e t h e y c r o s s -

c o r r e la t e d ?

² H o w d o e s Fe d e r a l R e s e r ve m o n e t a r y p o lic y a ®e c t ¯ n a n c ia l m a r ke t liqu id it y d u r in g

c r is e s ?

² W h a t h a p p e n s t o m o n e y ° o ws in a n d o u t o f s t o c k a n d b o n d m u t u a l fu n d s d u r in g

¯ n a n c ia l c r is e s a n d h o w d o e s t h is im p a c t s t o c k a n d b o n d m a r ke t liqu id it y?

Ou r g o a l in t h is p a p e r is t o a d d r e s s t h e s e qu e s t io n s b y c o n s id e r in g t h e jo in t t im e -s e r ie s

o f b o n d a n d s t o c k m a r ke t liqu id it y o ve r a fa ir ly lo n g t im e -p e r io d o f o ve r 1 7 0 0 t r a d in g

d a ys .

Th e r e s u lt s in d ic a t e t h a t t h e t im e s e r ie s p r o p e r t ie s o f s t o c k a n d b o n d liqu id it y p o s -

s e s s s im ila r it ie s . In p a r t ic u la r , r e s u lt s fr o m fo r e c a s t in g r e g r e s s io n s in d ic a t e t h a t b o n d

a n d s t o c k s p r e a d s a r e p r e d ic t a b le t o a c o n s id e r a b le d e g r e e , t h o u g h s t o c k s p r e a d s a r e

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