Market Volatility and Stock Returns: The Role of Liquidity Providers

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