Market Liquidity and Flow-Driven Risk

Review of Financial Studies, Forthcoming

AFA 2011 Denver Meetings Paper

58 Pages Posted: 21 Mar 2009 Last revised: 29 Jun 2011

Prachi Deuskar

Indian School of Business

Timothy C. Johnson

University of Illinois at Urbana-Champaign

Date Written: October 5, 2010

Abstract

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.

Keywords: systematic risk, market liquidity, order flow

JEL Classification: G12, G14

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: https://ssrn.com/abstract=1364611 or http://dx.doi.org/10.2139/ssrn.1364611

Prachi Deuskar (Contact Author)

Indian School of Business ( email )

Hyderabad, Gachibowli 500 019
India

Timothy C. Johnson

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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