Pricing of Liquidity Risks in London Stock Exchange

This thesis aims to investigate pricing of liquidity risks in London Stock Exchange. Liquidity Adjusted Capital Asset Pricing Model i.e. LCAPM developed by Acharya and Pedersen (2005) is being applied to test the influence of various liquidity risks on stock returns in London Stock Exchange. The Liquidity Adjusted Capital Asset Pricing model provides a unified framework for the testing of liquidity risks. All the common stocks listed and delisted for the period of 2000 to 2014 are included in the data sample. The study has incorporated three different measures of liquidity – Percent Quoted Spread, Amihud (2002) and Turnover. The reason behind the application of three different liquidity measures is the multi-dimensional nature of liquidity. Firm fixed effects panel regression is applied for the estimation of LCAPM. However, the results are robust according to Fama-Macbeth regressions. The results of the study indicates that liquidity risks in the form of (i) level of liquidity, (ii) commonality in liquidity (iii) flight to liquidity, (iv) depressed wealth effect and market return as well as aggregate liquidity risk are priced at London Stock Exchange. However, the results are sensitive to the choice of liquidity measures.

Essays on illiquidity premium

This dissertation is composed of three related essays on the relationship between illiquidity and returns. Chapter 1 describes the time-series properties of the relationship between market illiquidity and market return using both yearly and monthly datasets. We find that stationarized versions of the illiquidity measure have a positive, significant, and puzzling high premium. In Chapter 2, we estimate the response of illiquidity to a shock to returns, assuming that causality runs from returns to illiquidity and find that an increase in firms' returns lowers illiquidity. In Chapter 3 we take both effects into account and account for the endogeneity of returns and illiquidity to estimate the liquidity premium. We find evidence that the illiquidity premium is a smaller than the previous evidence suggests. Finally, Chapter 4 shows topics for future research where we describe a return decomposition with illiquidity costs.

Liquidity and asset pricing: A comparison between three-factor and three-moment capital asset pricing models

Liquidity is an important attribute of an asset that investors would like to take into consideration when making investment decisions. However, the previous empirical evidence whether liquidity is a determinant of stock return is not unanimous. This dissertation provides a very comprehensive study about the role of liquidity in asset pricing using the Fama-French (1993) three-factor and Kraus and Litzenberger (1976) three-moment CAPM as models for risk adjustment. The relationship between liquidity and well-known determinants of stock returns such as size and book-to-market are also investigated. This study examines the liquidity and asset pricing issues for both intertemporal as well as cross-sectional data. ^ The results indicate an existence of a liquidity premium, i.e., less liquid stocks would demand higher rate of return than more liquid stocks. More specifically, a drop of 1 percent in liquidity is associated with a higher rate of return of about 2 to 3 basis points per month. Further investigation reveals that neither the Fama-French three-factor model nor the three-moment CAPM captures the liquidity premium. Finally, the results show that well-known determinants of stock return such as size and book-to-market do not serve as proxy for liquidity. ^ Overall, this dissertation shows that a liquidity premium exists in the stock market and that liquidity is a distinct effect, and is not influenced by the presence of non-market factors, market factors and other stock characteristics.^

Liquidity, governance and adverse selection in asset pricing

A plethora of recent literature on asset pricing provides plenty of empirical evidence on the importance of liquidity, governance and adverse selection of equity on pricing of assets together with more traditional factors such as market beta and the Fama-French factors. However, literature has usually stressed that these factors are priced individually. In this dissertation we argue that these factors may be related to each other, hence not only individual but also joint tests of their significance is called for. ^ In the three related essays, we examine the liquidity premium in the context of the finer three-digit SIC industry classification, joint importance of liquidity and governance factors as well as governance and adverse selection. Recent studies by Core, Guay and Rusticus (2006) and Ben-Rephael, Kadan and Wohl (2010) find that governance and liquidity premiums are dwindling in the last few years. One reason could be that liquidity is very unevenly distributed across industries. This could affect the interpretation of prior liquidity studies. Thus, in the first chapter we analyze the relation of industry clustering and liquidity risk following a finer industry classification suggested by Johnson, Moorman and Sorescu (2009). In the second chapter, we examine the dwindling influence of the governance factor if taken simultaneously with liquidity. We argue that this happens since governance characteristics are potentially a proxy for information asymmetry that may be better captured by market liquidity of a company's shares. Hence, we jointly examine both the factors, namely, governance and liquidity - in a series of standard asset pricing tests. Our results reconfirm the importance of governance and liquidity in explaining stock returns thus independently corroborating the findings of Amihud (2002) and Gompers, Ishii and Metrick (2003). Moreover, governance is not subsumed by liquidity. Lastly, we analyze the relation of governance and adverse selection, and again corroborate previous findings of a priced governance factor. Furthermore, we ascertain the importance of microstructure measures in asset pricing by employing Huang and Stoll's (1997) method to extract an adverse selection variable and finding evidence for its explanatory power in four-factor regressions.^

Liquidity, Governance and Adverse Selection in Asset Pricing

A plethora of recent literature on asset pricing provides plenty of empirical evidence on the importance of liquidity, governance and adverse selection of equity on pricing of assets together with more traditional factors such as market beta and the Fama-French factors. However, literature has usually stressed that these factors are priced individually. In this dissertation we argue that these factors may be related to each other, hence not only individual but also joint tests of their significance is called for. In the three related essays, we examine the liquidity premium in the context of the finer three-digit SIC industry classification, joint importance of liquidity and governance factors as well as governance and adverse selection. Recent studies by Core, Guay and Rusticus (2006) and Ben-Rephael, Kadan and Wohl (2010) find that governance and liquidity premiums are dwindling in the last few years. One reason could be that liquidity is very unevenly distributed across industries. This could affect the interpretation of prior liquidity studies. Thus, in the first chapter we analyze the relation of industry clustering and liquidity risk following a finer industry classification suggested by Johnson, Moorman and Sorescu (2009). In the second chapter, we examine the dwindling influence of the governance factor if taken simultaneously with liquidity. We argue that this happens since governance characteristics are potentially a proxy for information asymmetry that may be better captured by market liquidity of a company’s shares. Hence, we jointly examine both the factors, namely, governance and liquidity – in a series of standard asset pricing tests. Our results reconfirm the importance of governance and liquidity in explaining stock returns thus independently corroborating the findings of Amihud (2002) and Gompers, Ishii and Metrick (2003). Moreover, governance is not subsumed by liquidity. Lastly, we analyze the relation of governance and adverse selection, and again corroborate previous findings of a priced governance factor. Furthermore, we ascertain the importance of microstructure measures in asset pricing by employing Huang and Stoll’s (1997) method to extract an adverse selection variable and finding evidence for its explanatory power in four-factor regressions.

Three essays on bankruptcy risk

Abstract Market prices of corporate bond spreads and of credit default swap (CDS) rates do not match each other. In this paper, we argue that the liquidity premium, the cheapest-to-deliver (CTD) option and actual market segmentation explain the pricing differences. Using the European transaction data from Reuters and Bloomberg, we estimate the liquidity premium that is time- varying and firm-specific. We show that when time-dependent liquidity premiums are considered, corporate bond spreads and CDS rates behave in a much closer way than previous studies have shown. We find that high equity volatility drives pricing differences that can be explained by the CTD option.

Trois essais sur la liquidité : ses effets sur les primes de risque, les anticipations et l'asymétrie des risques financiers

Thèse numérisée par la Division de la gestion de documents et des archives de l'Université de Montréal

La hipótesis de expectativas en la curva cero cupón: un análisis por cointegración

El cumplimiento de la hipótesis de expectativas (HE) ha sido contrastado en varios países por medio de diferentes métodos. En Colombia no se ha estudiado de manera conjunta las relaciones de largo plazo entre las tasas cero cupón. El presente trabajo busca contrastar el cumplimiento de la hipótesis de expectativas estimando un modelo multivariado con corrección de errores, de acuerdo a la metodología propuesta por Hall, Anderson y Granger (1992). La significancia de la prima por liquidez en las relaciones de largo plazo y las pruebas estadísticas del modelo favorecen el contraste de la HE. Sin embargo, la existencia de dos relaciones de cointegración y el rechazo de las relaciones teóricas esperadas indican el incumplimiento de la HE en Colombia.

Prêmio de liquidez no Brasil: um estudo sobre sua existência e seus impactos

Esse trabalho tem como objetivo investigar a existência de um prêmio de liquidez nas ações brasileiras. Através da construção de portfólios classificados por diferentes medidas de liquidez é possível testar o diferencial esperado de retorno e o risco incorrido. O retorno esperado do portfólio construído com ações menos líquidas é significantemente superior ao retorno do portfólio construído com as mais líquidas e as medidas convencionais de risco (mercado e fatores Fama-French) não explicam este excesso de retorno. Foram testadas diferentes medidas de liquidez sendo a metodologia proposta por Hwang e Lu (2007) aquela onde o efeito é mais considerável. Em conjunto, as evidências mostram a existência de um prêmio de liquidez no Brasil.

Essays on volatility and liquidity in financial markets

The price formation of financial assets is a complex process. It extends beyond the standard economic paradigm of supply and demand to the understanding of the dynamic behavior of price variability, the price impact of information, and the implications of trading behavior of market participants on prices. In this thesis, I study aggregate market and individual assets volatility, liquidity dimensions, and causes of mispricing for US equities over a recent sample period. How volatility forecasts are modeled, what determines intradaily jumps and causes changes in intradaily volatility and what drives the premium of traded equity indexes? Are they induced, for example, by the information content of lagged volatility and return parameters or by macroeconomic news, changes in liquidity and volatility? Besides satisfying our intellectual curiosity, answers to these questions are of direct importance to investors developing trading strategies, policy makers evaluating macroeconomic policies and to arbitrageurs exploiting mispricing in exchange-traded funds. Results show that the leverage effect and lagged absolute returns improve forecasts of continuous components of daily realized volatility as well as jumps. Implied volatility does not subsume the information content of lagged returns in forecasting realized volatility and its components. The reported results are linked to the heterogeneous market hypothesis and demonstrate the validity of extending the hypothesis to returns. Depth shocks, signed order flow, the number of trades, and resiliency are the most important determinants of intradaily volatility. In contrast, spread shock and resiliency are predictive of signed intradaily jumps. There are fewer macroeconomic news announcement surprises that cause extreme price movements or jumps than those that elevate intradaily volatility. Finally, the premium of exchange-traded funds is significantly associated with momentum in net asset value and a number of liquidity parameters including the spread, traded volume, and illiquidity. The mispricing of industry exchange traded funds suggest that limits to arbitrage are driven by potential illiquidity.

Do financial distress and liquidity crises affect value and size premiums?

This study investigates the impact of liquidity crises on the relationship between stock (value and size) premiums and default risk in the US market. It first examines whether financial distress can explain value and size premiums, and then, subsequently, aims to determine whether liquidity crises increase the risk of value and size premium investment strategies. The study employs a time-varying approach and a sample of US stock returns for the period between January 1982 and March 2011, a period which includes the current liquidity crisis, so as to examine the relationship between default risk, liquidity crises and value and size premiums. The findings indicate that the default premium has explanatory power for value and size and premiums, which affect firms with different characteristics. We also find that liquidity crises may actually increase the risks related to size and value premium strategies.

Prêmio sobre o risco (risk premium) dos títulos soberanos e política fiscal discricionária vs. regras de política fiscal para um país em desenvolvimento: o caso do Brasil

O projeto de pesquisa é parte do projeto entitulado "Credibilidade de Políticas Monetárias e Fiscais para o Brasil: Risco Soberano, Instituições, Âncoras Nominais, e Acesso aos Mercados Financeiros Internacionais". Dentro do atual plano de estabilização, um estudo empírico sobre a economia brasileira fornece um exemplo vívido do impacto de vários fatores, como o grau de institucionalização das políticas monetárias e orçamentárias que tem sido utilizadas desde a implementação do Plano Real, que aumentariam a credibilidade, sustentando a política cambial e o fluxo positivo do capital internacional, na percepção do mercado do risco de suspensão de pagamento (default risk) da dívida externa de um país em desenvolvimento. O foco dentro deste projeto de pesquisa será na questão de pesquisa: "Prêmio sobre o risco (risk premium) dos títulos soberanos e política fiscal discricionária vs regras de política fiscal para um país em desenvolvimento: o caso do Brasil".

US Corporate Default Swap Valuation: The Market Liquidity Hypothesis and Autonomous Credit Risk

This paper develops a reduced form three-factor model which includes a liquidity proxy of market conditions which is then used to provide implicit prices. The model prices are then compared with observed market prices of credit default swaps to determine if swap rates adequately reflect market risks. The findings of the analysis illustrate the importance of liquidity in the valuation process. Moreover, market liquidity, a measure of investors. willingness to commit resources in the credit default swap (CDS) market, was also found to improve the valuation of investors. autonomous credit risk. Thus a failure to include a liquidity proxy could underestimate the implied autonomous credit risk. Autonomous credit risk is defined as the fractional credit risk which does not vary with changes in market risk and liquidity conditions.

The role of pre-existing liquidity in determining pricing efficiency and liquidity gains following the introduction of SETSmm

In this paper we examine the impact that the new trading system SETSmm had on market quality measures such as firm value, liquidity and pricing efficiency. This system was introduced for mid-cap securities on the London Stock Exchange in 2003. We show that there is a small SETSmm return premium associated with the announcement that securities are to migrate to the new trading system. We find that migration to SETSmm also improves liquidity and pricing efficiency and these changes are related to the return premium. We also find that these gains are stronger for firms with high pre SETSmm liquidity and weaker for firms with low SETSmm liquidity.

The role of pre-existing liquidity in determining price efficiency and liquidity gains following the introduction of SETSmm

In this paper we examine the impact that the new trading system SETSmm had on market quality measures such as firm value, liquidity and pricing efficiency. This system was introduced for mid-cap securities on the London Stock Exchange in 2003. We show that there is a small SETSmm return premium associated with the announcement that securities are to migrate to the new trading system. We find that migration to SETSmm also improves liquidity and pricing efficiency and these changes are related to the return premium. We also find that these gains are stronger for firms with high pre SETSmm liquidity and weaker for firms with low SETSmm liquidity. © 2013 John Wiley & Sons Ltd.