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Market Liquidity and Flow-Driven Risk

Prachi Deuskar

Indian School of Business

Timothy C. Johnson

University of Illinois at Urbana-Champaign

October 5, 2010

Review of Financial Studies, Forthcoming
AFA 2011 Denver Meetings Paper

Using a unique data set of trades and limit orders for S&P 500 futures, we decompose the aggregate risk into a component driven by the impact of net market orders and a component unrelated to net orders. The first component -- flow-driven risk -- is large, accounting for approximately 50 percent of market variance, and it is not transient. This risk represents the joint effect of net trade demand and the price impact of that demand i.e. illiquidity. We find that flows are largely unpredictable, and lagged flows have no price impact. Flow-driven risk is time varying because price impact is highly variable. Illiquidity rises with market volatility, but not with flow uncertainty. Net selling increases illiquidity, which amplifies downside flow-driven risk. The findings are consistent with flow-driven shocks resulting from fluctuations in aggregate risk-bearing capacity. Under this interpretation, investors with constant risk tolerance should trade against such shocks (i.e. "supply liquidity") to achieve substantial utility gains. Quantitatively accounting for the scale of flow-driven risk poses a major challenge for asset pricing theory.

Number of Pages in PDF File: 58

Keywords: systematic risk, market liquidity, order flow

JEL Classification: G12, G14

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Date posted: March 21, 2009 ; Last revised: June 29, 2011

Suggested Citation

Deuskar, Prachi and Johnson, Timothy C., Market Liquidity and Flow-Driven Risk (October 5, 2010). Review of Financial Studies, Forthcoming; AFA 2011 Denver Meetings Paper. Available at SSRN: http://ssrn.com/abstract=1364611 or http://dx.doi.org/10.2139/ssrn.1364611

Contact Information

Prachi Deuskar (Contact Author)
Indian School of Business ( email )
Hyderabad, Gachibowli 500 019
Timothy C. Johnson
University of Illinois at Urbana-Champaign ( email )
601 E John St
Champaign, IL 61820
United States
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