Evaporating Liquidity

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.