Evaporating Liquidity

Nagel, Stefan

doi:10.2139/ssrn.1573164

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Evaporating Liquidity

AFA 2011 Denver Meetings Paper

49 Pages Posted: 22 Mar 2010 Last revised: 23 Jul 2011

See all articles by Stefan Nagel

Stefan Nagel

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research; CESifo (Center for Economic Studies and Ifo Institute)

There are 3 versions of this paper

Date Written: October 1, 2010

Abstract

The returns of short-term reversal strategies in equity markets can be interpreted as a proxy for the returns from liquidity provision. Analysis of reversal strategies shows that the expected return from liquidity provision is strongly time-varying and highly predictable with the VIX index. Expected returns and conditional Sharpe Ratios increase enormously along with the VIX during times of financial market turmoil, such as the financial crisis 2007-09. Even reversal strategies formed from industry portfolios (which do not yield high returns unconditionally) produce high rates of return and high Sharpe Ratios during times of high VIX. The results point to withdrawal of liquidity supply, and an associated increase in the expected returns from liquidity provision, as a main driver behind the evaporation of liquidity during times of financial market turmoil, consistent with theories of liquidity provision by financially constrained intermediaries.

Keywords: Liquidity, Immediacy, Reversal Strategies, VIX, Financial Crisis

JEL Classification: G12, G01

Suggested Citation: Suggested Citation

Nagel, Stefan, Evaporating Liquidity (October 1, 2010). AFA 2011 Denver Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1573164 or http://dx.doi.org/10.2139/ssrn.1573164