Stock Market Declines and Liquidity

Abstract

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.

Keywords: Liquidity, Market decline, Liquidity commonality, Price reversal

JEL Classification: G19