Doctoral School of Finance and Banking Liquidity indicator and liquidity risk pricing for Bucharest Stock Exchange Supervisor: Professor Moisa Altar MSc 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

Motivation of the Study

Market Liquidity Indicator The model was developed by Stambaugh and Pastor (2003) (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 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? (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

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 ; average residuals correlation across stocks is ; Model (2) – doesn’t fit very well liquidity breakdowns; correlation with market returns during low liquidity months is ; average residuals correlation across stocks is

Market Liquidity Indicator “Flight to Quality” effect Stock market returns and trading volume decrease when liquidity is low, but government bonds yield goes up

Is liquidity risk priced? We investigate wheather a stock’s expected return is related to the sensitivity of its return to agregate liquidity indicator, -Explains a component of expected return which is not captured by exposures to market risk (factors of Fama and French (1993))

Is liquidity risk priced?

Normal Kernel Distribution for Liquidity Indicator Normal Kernel Distribution for Liquidity Betas

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, 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, Wagner, N. and T.A. Marsh (2004), “Surprise Volume and Heteroskedasticity in Equity Market Returns”, available at SSRN: 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:

Thank you!