Evaporating Liquidity

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

Stefan Nagel

University of Michigan, Stephen M. Ross School of Business; University of Michigan Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research

Multiple version iconThere 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

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

Stefan Nagel (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

University of Michigan Department of Economics

Lorch Hall
Ann Arbor, MI 48109
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Paper statistics

Downloads
254
Rank
66,099
Abstract Views
1,485