Working Paper: NBER ID: w14013
Authors: Jennifer Huang; Jiang Wang
Abstract: In this paper, we develop an equilibrium model for stock market liquidity and its impact on asset prices when constant market presence is costly. We show that even when agents' trading needs are perfectly matched, costly market presence prevents them from synchronizing their trades and hence gives rise to endogenous order imbalances and the need for liquidity. Moreover, the endogenous liquidity need, when it occurs, is characterized by excessive selling of significant magnitudes. Such liquidity-driven selling leads to market crashes in the absence of any aggregate shocks. Finally, we show that illiquidity in the market leads to high expected returns, negative and asymmetric return serial correlation, and a positive relation between trading volume and future returns. We also propose new measures of liquidity based on its asymmetric impact on prices and demonstrate a negative relation between these measures and expected stock returns.
Keywords: liquidity; market crashes; asset prices
JEL Codes: E43; E44; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| endogenous need for liquidity (E41) | significant order imbalances (C69) |
| significant order imbalances (C69) | asset prices drop sharply (G19) |
| endogenous need for liquidity (E41) | asset prices drop sharply (G19) |
| illiquidity in the market (G10) | high expected returns (G17) |
| illiquidity in the market (G10) | negative serial correlation in returns (G17) |
| negative impact of liquidity needs (F65) | higher volatility (G17) |
| negative impact of liquidity needs (F65) | asymmetric return distributions (C46) |
| higher volatility (G17) | more pronounced effects during periods of negative returns (G41) |