1 Sources of Commonality in Liquidity and Factors Affecting the by maclaren1


									  Sources of Commonality in Liquidity and
Factors Affecting the Pricing of Commonality

             Dissertation Proposal
              Presented to the Faculty of
        Department of Economics and Finance
              University of New Orleans
      In Partial Fulfillment of the Requirements
                   For the Degree of
            Ph.D. in Financial Economics

                Mehmet F. Dicle
                 Ph.D. Candidate
       Department of Economics and Finance
            University of New Orleans
          2000 Lakeshore Drive, KH 438
             New Orleans, LA 70148
               Tel. (504) 858-9342
               Fax: (504) 280-6397
            E-Mail: mfdicle@uno.edu

             University of New Orleans
                   August, 2007

                         Sources of Commonality in Liquidity and

                      Factors Affecting the Pricing of Commonality

    Liquidity is not directly measurable. Therefore, the evaluation of individual security

liquidity is limited to several proxies of liquidity rather than a specific measure. Earlier

studies emphasize on determinants of liquidity, especially on the inventory costs and

asymmetric information aspects. With the availability of intraday transaction data, recent

studies take advantage of more precise proxies of liquidity such as bid-ask spreads and

depth. The direction of emphasis is changed towards the relationship between return and

liquidity. Along with individual liquidity, aggregate market liquidity is also evaluated

extensively with the focus on asset pricing aspects. In both strands of literature, liquidity

is considered to be a priced risk. Lo, Mamaysky and Wang (2001) provide a survey of

earlier liquidity studies.

    More recently, the focus is shifted towards common factors determining liquidity for

individual as well as market-wide liquidity. Commonality in liquidity is evaluated as a

new determinant of individual liquidity. Chordia, Roll, and Subrahmanyam (2000) and

Huberman and Halka (2001) provide evidence for the relationship between individual

and market liquidity in the U.S. markets. Lee (2005) and Brockman, Chung and Perignon

(2006) provide evidence of commonality in liquidity for the international markets. It is

argued that if there is a common determinant of individual liquidity, then individual

stocks will have commonality in their liquidity proxies. Inventory costs and asymmetric

information are considered to be the most plausible determinants that may show com-

monality. Volatility of shares has a commonality and any change in volatility will have

an impact on the inventory risks of market makers. Order imbalances will distract inven-

tory balances and will eventually increase transaction costs. If, on the other hand, the

number of informed traders increase or their information is more common than stock spe-

cific, market makers will become more susceptible to order imbalances for several stocks

at a time. In turn, they will increase transaction costs to decrease their inventory turnover

ratio. Pastor and Stambaugh (2003) argue that market liquidity is non-diversifiable and a

factor for asset pricing. Acharya and Pedersen (2005) argue that the covariance between

market liquidity and individual liquidity is a factor in asset pricing.

    There is sufficient evidence for commonality in liquidity for U.S. markets using li-

quidity proxies based on transaction data. While only a few studies evaluate international

markets, the evidence is robust both based on transaction data and daily data. The meth-

odology introduced by Acharya and Pedersen (2005) integrates individual liquidity and

market liquidity into asset pricing which is relatively new and unexplored. There are only

a few applications of Acharya and Pedersen (2005) for international markets (i.e. Lee,

2005). However, liquidity is an important aspect for developing markets. Considering the

fact that several previous financial crises were blamed on diminished market-wide liquid-

ity, better understanding of liquidity will also shed light on the differences specific to

emerging markets. Our aim with this study is to identify some of the sources of common-

ality in liquidity and factors affecting the pricing of liquidity by comparing emerging

markets to developed markets.

    We suspect that commonality has its sources in inventory as well as asymmetric in-

formation explanations. The market structure in terms of existence of market makers with

the obligation to provide liquidity will play an important role in commonality. Traders in

auction markets have motivations to trade and no obligation. While such difference in

market structure is considered a possible source in commonality, the traders’ behavior

under different market conditions is more plausible. If a market experiences rather large

negative returns on a frequent basis, it is only natural to expect traders to be more cau-

tious during down markets. If the market trading stops frequently due to circuit-brakers,

traders have no alternative to rebalance their inventories. Even if these negative returns

are not significant but rather in longer durations, it will alter the trading patterns of the

investors. Thus, the magnitude and duration of market downside risk will affect liquidity

and its commonality. Chordia, Roll, and Subrahmanyam (2001) argue that rate of change

in transaction costs are different for down and up markets. Chordia, Roll, and Subrah-

manyam (2002) show that order imbalances during down and up markets increase the

inventory risks and lead to increased transaction costs. Considering the transaction costs

as a reaction to market-wide movements, higher volatility will lead to higher transaction

costs. However, if there is over-reaction in down markets and under-reaction in up mar-

kets, then the commonality and pricing of commonality should be higher in down mar-

kets compared to the up markets. As the first source of commonality, we will evaluate

commonality and pricing of commonality for down and up markets. Since emerging mar-

kets are generally auction markets, the inexistence of dealers (or market makers) will in-

fluence the trading patterns. After all, the traders in auction markets have no obligation to

provide liquidity. Galariotis and Giouvris (2007) evaluate this issue for FTSE 100 and

FTSE 250 stocks in U.K. by extending Chordia, Roll, and Subrahmanyam (2000). They

find that the effect of difference in trading regime on commonality is small. With this in

mind, we will base our explanations on inventory explanations. Our only difference will

be the motivation for investors to trade which is purely to make profits rather than mak-

ing profits and the obligation. We suspect that the traders in emerging markets are more

cautious in down markets against further declines, circuit breakers (which make inven-

tory balancing impossible) and major market crashes. Therefore, as the second source of

commonality, we will evaluate the effect of frequency of large negative returns (size of

downside risk) on commonality and pricing of commonality.

    Another source we consider is the correlation of equity markets with macroeconomic

factors. We suspect that the short- and long-term interest rates will influence cost of car-

rying inventory and in turn affect commonality. Chordia, Roll, Subrahmanyam (2001)

show the effect of interest rates and announcements of macroeconomic events on market

liquidity and trading activity. These announcements, if known beforehand, will be re-

ceived as information about the overall market contributing to market-wide trading thus

affecting the commonality. Therefore, as the third source of commonality, we will evalu-

ate the effect of macroeconomic factors on commonality and pricing of commonality.

    Lee (2005) shows that liquidity risk is also an international issue. While it is ex-

pected that developed markets should have influence over the liquidity of emerging mar-

ket, we suspect that there should be commonality in liquidity between markets as well.

Lee (2005) provides evidence for the effect of U.S. equity markets on liquidity risk of

international markets. This evidence implies that the common factors in determinants of

individual (and market) liquidity within a single market may have commonality between

markets. The evidence provided by Brockman, Chung and Perignon (2006) using 38

countries is in support of this view. Therefore, as the fourth source of commonality, we

will examine the existence of any commonality between markets.

    Seasonality in returns may disappear after being documented. This is largely because

these patterns provide opportunities for investors to profit. Draper and Paudyal (1997)

provide evidence for the existence of seasonality in London Stock Exchange. In their

evaluation of liquidity determinants, Chordia, Roll, Subrahmanyam (2001) provide evi-

dence that some known seasonality effects such as day-of-the-week and holidays effect

liquidity and trading activity. Seasonality in liquidity is much more persistent. This is be-

cause, if there is any pattern of low liquidity, traders tend to avoid trading during these

times causing these patterns to persist. We suspect that seasonality in liquidity is another

source for commonality. Therefore, as the fifth source of commonality, we will examine

the seasonality in commonality and pricing of commonality.

    Our contribution is towards the understanding of sources of commonality and factors

affecting the pricing of commonality. By extending the current literature to evaluate the

emerging markets in terms of differences to developed markets with reference to com-

monality and pricing of commonality in liquidity, we contribute to the understanding of

channels in which the commonality is formed and priced. Understanding the sources of

commonality will contribute to the literature for asset pricing, market microstructure and

liquidity. While our evaluation is focused on the emerging markets, the issue is relevant

to developed markets as well. Since liquidity is generally blamed for financial crises in

emerging markets, by examining the liquidity in down and up markets separately, we are

also contributing to the literature about the financial crisis proneness in emerging mar-

kets. Due to the covariance of liquidity and returns, seasonal patterns in commonality

contributes towards explanations for well-known market anomalies.


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