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
October 1, 2010
AFA 2011 Denver Meetings Paper
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.
Number of Pages in PDF File: 49
Keywords: Liquidity, Immediacy, Reversal Strategies, VIX, Financial Crisis
JEL Classification: G12, G01
Date posted: March 22, 2010 ; Last revised: July 23, 2011