Market Volatility and Stock Returns: The Role of Liquidity Providers

58 Pages Posted: 4 Apr 2017 Last revised: 18 Apr 2018

See all articles by Kee H. Chung

Kee H. Chung

State University of New York at Buffalo - School of Management

Chairat Chuwonganant

Kansas State University - Department of Finance

Date Written: April 2, 2017

Abstract

This study shows that market volatility affects stock returns both directly and indirectly through its impact on liquidity provision and the negative relation between market volatility and stock returns arises not only from greater risk premiums but also greater illiquidity premiums that are associated with higher market volatility. In particular, we show that a stock’s return is more sensitive to unexpected changes in market volatility when its liquidity disappears more in response to volatility shocks, which indicates that liquidity providers play an important role in determining the effect of market volatility on stock returns. Stock returns are more sensitive to volatility shocks in the high-frequency trading era, and after the regulatory changes in the US markets that increased competition between public traders and market makers, reduced the tick size, and decreased the role of market makers.

Keywords: Market Volatility, Risk Premium, VIX, Liquidity Shock, Bid-Ask Spread, Price Impact, Stock Returns, Market Structure

JEL Classification: G01, G02, G10, G18

Suggested Citation

Chung, Kee H. and Chuwonganant, Chairat, Market Volatility and Stock Returns: The Role of Liquidity Providers (April 2, 2017). Available at SSRN: https://ssrn.com/abstract=2945030 or http://dx.doi.org/10.2139/ssrn.2945030

Kee H. Chung (Contact Author)

State University of New York at Buffalo - School of Management ( email )

Buffalo, NY 14260
United States
716-645-3262 (Phone)
716-645-3823 (Fax)

HOME PAGE: http://mgt.buffalo.edu/faculty/academic-departments/finance/faculty/kee-chung.html

Chairat Chuwonganant

Kansas State University - Department of Finance ( email )

Manhattan, KS 66506
United States

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