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Stock Market Declines and Liquidity

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1 Stock Market Declines and Liquidity* Allaudeen Hameed Wenjin Kang and S. Viswanathan This version: December 31, 2007 * Hameed and Kang are from the Department of Finance, National University of Singapore, Singapore 117592, Tel: 65-6516-3034 and 65-6516-3194, Fax: 65-6779-2083, [email protected] and [email protected] Viswanathan is from the Fuqua School of Business, Duke University , Tel: 1-919-660-7782, Fax: 1-919-660-7971, [email protected] We thank Viral Acharya, Yakov Amihud, Michael Brandt, Markus Brunnermeier, Andrew Ellul, Bob Engle, Doug Foster, Joel Hasbrouck, David Hsieh, Pete Kyle, Ravi Jagannathan, Christine Parlour, David Robinson, Ioanid Rosu, Avanidhar Subrahmanyam, Sheridan Titman and participants at the NBER 2005 microstructure conference, 2007 American Finance Association meeting, 2007 European Finance Association Meeting, Case Western Reserve University, Hong Kong University of Science and Technology, National University of Singapore, New York University, University of Alberta, University of Evry (France), University of Melbourne, University of Texas (Austin), for their comments. Hameed and Kang acknowledge the financial support from the NUS Academic Research Grants.2ABSTRACT The evidence presented in this paper suggests that asset-side shock affecting the funding available to financial intermediaries contributes to significant time-variation in liquidity. Consistent with recent theoretical models where binding capital constraints lead to sudden liquidity dry-ups, we find that negative market returns decrease stock liquidity, especially for high volatility stocks and during times of tightness in the funding market. The asymmetric effect of changes in aggregate asset values on liquidity and commonality in liquidity cannot be fully explained by changes in demand for liquidity or volatility effects. We document inter-industry spill-over effects in liquidity, which are likely to arise from capital constraints in the market making sector. We also find economically significant returns to supplying liquidity following periods of large drop in market valuations.31. Introduction In recent theoretical research, the idea that market declines cause asset illiquidity has received much attention. Liquidity dry-ups occur either because market participants engage in panic selling (a demand effect) or financial intermediaries withdraw from providing liquidity (a supply effect) or both. Following these theories, we explore what happens to market liquidity after large market declines and ascertain whether supply effects exist in equity markets. However, it is difficult to establish the actual identity of financial intermediaries in these markets as they could be specialists, floor traders, limit order providers or others like hedge funds. Furthermore, the actual positions and balance sheet of these intermediaries are also unknown. Hence, in this paper, we take an encompassing approach by investigating the impact of market declines on various dimensions of liquidity, including: (a) time-series as well as cross-sectional variations in liquidity; (b) commonality in liquidity; and (c) cost of liquidity provision. Theoretical models obtain illiquidity after market declines in a variety of ways. In Gromb and Vayanos (2002), Anshuman and Viswanathan (2005) and Brunnermeier and Pedersen (2007), market makers make market by absorbing temporary liquidity shocks. However, they also face funding constraints and obtain financing by posting margins and pledging the securities they hold as collateral. When stock prices decline considerably, the intermediaries hit their margin constraints and are forced to liquidate. In Brunnermeier and Pedersen (2007), a large market shock triggers the switch to a low-liquidity, high margin equilibrium, where markets are illiquid, resulting in larger margin requirements. This illiquidity spiral restricts dealers further from providing market liquidity. Anshuman and Viswanathan (2005), on the other hand, present a4slightly different model where leveraged investors are asked to provide collateral when asset values fall and decide to endogenously default, leading to asset liquidation. At the same time, market makers face funding constraints as they are able to finance less in the repo market for the assets they own. Gromb and Vayanos (2002) emphasize that the reduction in supply of liquidity due to capital constraints has important welfare and regulatory implications. Partly motivated by the LTCM crises, the balance sheet of intermediaries matter in these collateral based models as they face financial constraints that are often binding precisely when it is most incumbent for them to provide liquidity.1 The providers of liquidity in these models become demanders of liquidity after a large drop in asset prices causing both a demand effect (more liquidity is demanded) as well as a supply effect (less able to provide liquidity). In limits to arbitrage based models such as Kyle and Xiong (2001) and Xiong (2001), shocks to noise traders make prices move away from fundamentals and arbitrageurs provide liquidity and take advantage of the arbitrage opportunity. However, these liquidity providers face decreasing absolute risk aversion. Following market declines, their demand for risky assets declines, and they become liquidity demanders as they liquidate their positions in risky assets. In the coordination failure models of Bernardo and Welch (2003) and Morris and Shin (2004), traders face differing trading limits that would cause them to sell. Since one trader hitting his limit may push down the price and make other traders’ limits to be hit, early liquidation gives a better price than late liquidation. Here, traders rush to liquidate following negative shocks, and when prices fall enough, liquidity black holes emerge, analogous to a bank run model. Vayanos 1 This spiral effect of a drop in collateral value is emphasized in a number of theoretical papers, starting with the foundational work in Kiyotaki and Moore (1997), where lending is based on the value of land as collateral. See also Allen and Gale (2005).5(2004) presents an asset pricing model where investors have to liquidate when asset prices fall below a lower bound, leading to liquidation risk being priced. Vayanos links the risk of needing to liquidate to volatility, especially for stocks with large exposure to market volatility. While the exact details of


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