Bachelor Thesis Rick van Delft

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<ul><li><p>Tilburg University </p><p>Stock Market and Liquidity </p><p>Has liquidity increased after the start of the financial crisis? </p><p>Bachelor Thesis Finance </p><p>Rick van Delft </p><p>ANR: 921290 </p><p>Supervisor: </p><p>Zorka Simon </p><p>17-05-2013 </p></li><li><p>2 </p><p>Index </p><p>Introduction ............................................................................................................................................. 3 </p><p>What is the definition of Liquidity? ......................................................................................................... 6 </p><p>The level of liquidity ........................................................................................................................ 6 </p><p>Liquidity Risk .................................................................................................................................... 7 </p><p>The characteristics of stock liquidity ................................................................................................... 8 </p><p>How can liquidity be measured? ....................................................................................................... 10 </p><p>The bid ask-spread ........................................................................................................................ 11 </p><p>The ILLIQ-measure ......................................................................................................................... 11 </p><p>The turnover ratio ......................................................................................................................... 12 </p><p>What is the expected relationship between liquidity and the stock market? .................................. 13 </p><p>What is the role of liquidity in a financial crisis? ............................................................................... 14 </p><p>Empirical Evidence................................................................................................................................. 16 </p><p>Data description ................................................................................................................................ 16 </p><p>The Models ........................................................................................................................................ 16 </p><p>The variables ..................................................................................................................................... 16 </p><p>The Working Method ........................................................................................................................ 18 </p><p>Empirical Results ................................................................................................................................... 21 </p><p>Conclusion ............................................................................................................................................. 27 </p><p>Bibliography ........................................................................................................................................... 29 </p><p>Appendix 1: ............................................................................................................................................ 31 </p><p>Amihud &amp; Mendelson (1986) Asset Pricing and the Bid-Ask Spread ............................................ 31 </p><p>Appendix 2 ............................................................................................................................................. 34 </p><p>Datar, Naik, and Radcliffe (1998) Liquidity and Stock Returns: An Alternative Test..................... 34 </p><p>Appendix 3: Results Turnover Rate Model ............................................................................................ 36 </p><p>Appendix 4: Descriptive Statistics of the Turnover rate Model ............................................................ 39 </p><p>Appendix 5: Results Relative Bid-ask spread Model ............................................................................. 40 </p><p>Appendix 6: Descriptive Statistics of the Relative Bid-Ask spread model ............................................. 43 </p><p>Appendix 7: Results Bid-ask spread Model ........................................................................................... 44 </p><p>Appendix 8: Descriptive Statistics of the Bid-ask spread Model ........................................................... 47 </p><p>Appendix 9: Descriptive statistics summary of the Bid-ask spread ...................................................... 48 </p></li><li><p>3 </p><p>Introduction </p><p>In times of financial instability, investors are more and more interested in the sources which </p><p>can affect their positions. There are several frictions in the market which can affect the </p><p>investors position. Liquidity is one of them. Within liquidity a distinction can be made </p><p>between the level of liquidity (which is asset specific) and the liquidity risk (which is the </p><p>systematic risk of an asset). The level of liquidity is an important aspect of affecting the assets </p><p>returns. Amihud and Mendelson (1986) state that: liquidity, marketability or trading costs </p><p>are among the primary attributes of many investment plans and financial instruments. A </p><p>simple definition of liquidity is the ability to sell or buy stocks at low cost without affecting </p><p>the price. (Pastor and Stambaugh (2003)) In the same paper they also refer to liquidity as a </p><p>source of systematic risk. Acharya and Pedersen (2005) suggest that there are differences in </p><p>the effect of the liquidity level and the liquidity risk. Because of the costs liquidity is seen as </p><p>an important factor and therefore interest in liquidity has increased. Gomber, Schweikert and </p><p>Theissen (2004) argue its importance because: It affects the transaction costs for investors, </p><p>and it is a decisive factor in the competition for order flow among exchanges, and between </p><p>exchanges and proprietary trading systems. </p><p>Many studies have investigated the relationship between liquidity and the stock market. </p><p>Amihud and Mendelson (1986) studied this relationship between the differences of securities </p><p>bid-ask price on their returns. The difference of the bid- and ask-price is called the spread. </p><p>They find that higher yields required on higher-spread stocks give an incentive to firms to </p><p>enlarge the liquidity of their stocks and thereby reducing their opportunity cost of capital. In </p><p>this way, increasing liquidity can make the firm more valuable. In a later study in 2002, </p><p>Amihud proposes there is a risk premium for stocks excess return. The simple clarification for </p><p>this is because a compensation risk is needed when an investor is exposed to some more risk. </p><p>However, he relates the risk premium also to illiquidity. Illiquidity is the opposite of liquidity, </p><p>thus the higher the spread, the more illiquid a stock is. So, the risk premium is not only </p><p>reflecting the higher risk, it is too a premium for stock illiquidity. </p><p>In the past few decades, many researchers have tried to describe the relationship between </p><p>liquidity and the stock market. They disagree strongly about the best measure of liquidity. </p><p>Kyle (1985) describes market liquidity as: a slippery and elusive concept. So, the factors of </p><p>market liquidity are already hard to define. To measure these factors is thus even harder. </p><p>However, many researches proxy liquidity by using the bid-ask spread. Another measure </p></li><li><p>4 </p><p>often used is the turnover ratio. This ratio can be calculated on several ways which makes it </p><p>known as a measure where many adjustments can be made. </p><p>The aim of this study is to understand the relation between stocks and liquidity and the </p><p>changes in liquidity over the last 15 years. I will use this time frame in particular with respect </p><p>to the financial crisis. Amihud and Mendelson (1986) used data for the period 1961-1980. </p><p>Datar, Naik and Radcliffe (1998) used a sample in the period from July 1962 through </p><p>December 1991. To see whether the same relationship holds for a later period, I will use a </p><p>time-span from January 1997 to December 2012. I will use the same measures of liquidity as </p><p>described in the papers by Amihud and Mendelson (1986) and Datar et al (1998). I have </p><p>chosen for these measures because Amihud and Mendelson (1986) were the first researchers </p><p>with an empirical study about the relationship between liquidity and the stock market. They </p><p>used the differences between the bid-ask price, the spread, to measure liquidity. Datar et al </p><p>(1998) have studied the same relationship, though they used an alternative measure, the </p><p>turnover rate to proxy liquidity. The reason for using this paper is because Petersen and </p><p>Fialkowski (1994) concluded that the quoted spread is not a good proxy for the real </p><p>transaction costs for investors. Thereby, Amihud and Mendelson (1986) give a theoretical link </p><p>between the turnover rate and liquidity. So to test this relationship, I am going to use the </p><p>measure provided by Datar et al (1998). </p><p>The time-span I will use is of interest because of the financial crisis. Brunnermeier (2008) </p><p>studied some of the leading key factors which caused the financial crisis. He also includes </p><p>liquidity as one of the main causes of the financial crisis. He argues that in 2006, many </p><p>investors had put their money in illiquid assets. So they were exposed to liquidity risk, as </p><p>already explained by Amihud (2002). Brunnermeier (2008) and Brunnermeier and Pedersen </p><p>(2009) divided the concept of liquidity into market liquidity and funding liquidity. Through a </p><p>mechanism between these two drivers of liquidity, which later will be explained further, a </p><p>relative small shock can cause liquidity to dry up suddenly and carry the potential for a full-</p><p>blown financial crisis. [Brunnermeier (2008)] </p></li><li><p>5 </p><p>The next chapter will summarize the most important papers about how liquidity is related to </p><p>the stock market. To start with, an explanation of liquidity will be giving. Later the theoretical </p><p>relationship between liquidity and the stock market will be illustrated. Further, liquidity in </p><p>times of a financial crisis will be described. In section 3, the research methodology is going to </p><p>be introduced. The result of the tests will be explained in section 4, whereas section 5 will </p><p>summarize the results and conclusions can be made. </p></li><li><p>6 </p><p>What is the definition of Liquidity? </p><p>The level of liquidity </p><p>Liquidity has many interpretations. The simplest way is to define liquidity as trading an asset </p><p>which could be sold immediately without any costs. Kyle (1985) interprets liquidity as an </p><p>elusive concept of some characteristics of transactional markets which you can distinguish in: </p><p>tightness, depth and resiliency. He states that tightness refers to the difference between the </p><p>bid- and the ask-quotes. Normally for stocks, a bid-price is slightly below the equilibrium </p><p>price whereas the ask-price is higher than the equilibrium price. So if the market is tighter, the </p><p>difference (the spread) between the bid- and the ask-price is smaller and thus the market is </p><p>more liquid. Perfect liquidity could be reached when there is zero spread between the quotes. </p><p>This facet is most commonly used to describe liquidity. However, this measure is only useful </p><p>for trading with low volumes. Larger orders are facing price reactions within the trade, only </p><p>tightness as a measure will not be enough. Thereafter, Kyle uses another concept: depth. Kyle </p><p>explains depth as: the size of an order flow innovation required to change prices a given </p><p>amount. Basically, it is the amount of trades which can be made without affecting the quote. </p><p>Engle and Lange (1997, 2001) have explained depth and tightness in the figure (the market </p><p>reaction curve) below: </p><p>The amount of trading in relation to the depth is here graphically explained by the horizontal </p><p>line as well by the rising line. Low trading volumes do not have an effect on the price which </p><p>is explained by the flat line, whereas the price is rising when the volume of trading becomes </p><p>bigger. The other concept of liquidity is resilience. Resiliency considers the speed of return </p><p>to the efficient price after a random deviation. [Engle and Lange (1997)] Based on the figure </p><p>Source: Engle and Lange (1997) </p></li><li><p>7 </p><p>above, it could be seen as the time it will need to go back to the equilibrium level. There is </p><p>one problem; the equilibrium level has to be estimated. The estimation is very difficult </p><p>because of all sorts of new information could become available in the market, so there is no </p><p>clear point of reference of an equilibrium. This could also be a reason why Kyle states that </p><p>market liquidity is a slippery and elusive concept. Therefore, it is hard to measure liquidity. </p><p>Damoradan (2005) describes liquidity differently. As already said, a simple form of defining </p><p>liquidity is as trading an asset which could be sold immediately without any costs. The </p><p>definition given by Damoradan comes closer to this simple view. Whereas the Kyles </p><p>arguments are more related to the trading aspect and market microstructure, Damoradans </p><p>interpretation of liquidity comes closer to the cost of liquidity, namely: </p><p>When you buy a stock, bond, real asset or a business, you sometimes face buyers remorse, </p><p>where you want to reverse your decision and sell what you just bought. The cost of illiquidity </p><p>is the cost of this remorse. </p><p>Liquidity Risk </p><p>The given definition of liquidity has to do with the level of liquidity. Kyles definitions are </p><p>stock specific, namely what or how liquidity is priced at a transaction. Another distinction </p><p>about liquidity can be made with the systematic liquidity risk. The systematic liquidity risk is </p><p>argued by Pastor and Stambaugh (2003). They investigated the market wide liquidity and the </p><p>correlation of it with the pricing of assets. Acharya and Pedersen (2005) found empirical </p><p>evidence to distract the level of liquidity of liquidity risk. They even argue that: liquidity risk </p><p>contributes on average about 1.1% annually to the difference in risk premium between stocks </p><p>with high expected illiquidity and low expected illiquidity. Although, the whole analysis they </p><p>made was complicated though the collinearity they faced. This is because when securities are </p><p>illiquid, they tend to have also high liquidity risk. Pastor and Stambaugh (2003) identified that </p><p>if the market liquidity drops heavily, stocks returns are correlated in a negative way with </p><p>fixed-income returns. This seems valid with the flight-to-quality, which will be explained </p><p>later in the paragraph of the role of liquidity in the financial crisis. Due to the collinearity in </p><p>the study of Acharya and Pedersen (2005), it is difficult to distinguish the impact of the level </p><p>of liquidity as well as the liquidity risk. The collinearity exists because highly illiquid </p><p>securities often have high commonality in liquidity with the market liquidity, have a higher </p><p>sensitivity to market liquidity and to market returns. Thus, the relationship of all these types is </p><p>complicated to recognize. However, there is another type of risk which has to be mentioned </p></li><li><p>8 </p><p>here, the r...</p></li></ul>