The Information Environment, Volatility Structure, and Liquidity

Abstract

A central theme in existing literature is that increased disclosure and transparency reduce the level of information asymmetry between market makers and informed traders and thus increase liquidity. In contrast, in this study we propose and empirically investigate a new and unexplored channel through which the information environment can affect liquidity. We predict that for a given level of information asymmetry, or even absent information asymmetry, reduced disclosure and less transparent information environments make changes in the firm's stock price more discontinuous (jumpy) and hence change the structure of volatility. We further predict that market makers reduce liquidity as a result, because it is significantly more difficult for them to hedge discontinuous price changes (jump volatility) to their inventory than continuous price changes (diffusive volatility). Using both associations and causal tests we find a negative relation between the transparency of the information environment and jump volatility. We then show that jump volatility is negatively associated with liquidity, even after controlling for information asymmetry, while diffusion has a positive association. Finally, we present causal evidence that the information environment affects liquidity through jump volatility. Our findings have implications for our understanding of liquidity, corporate finance decisions, and policy-makers.

Keywords: Disclosure, Information enviornment, Liquidity, Liquidity risk, Volatility, Jump