Liquidity Creation As Volatility Risk

43 Pages Posted: 8 Mar 2018

See all articles by Itamar Drechsler

Itamar Drechsler

Wharton School, Department of Finance; National Bureau of Economic Research (NBER)

Alan Moreira

University of Rochester - Simon Business School

Alexi Savov

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Date Written: March 2, 2018

Abstract

We show, both theoretically and empirically, that liquidity creation induces negative exposure to volatility risk. Intuitively, liquidity creation involves taking positions that can be exploited by privately informed investors. These investors' ability to predict future price changes makes their payoff resemble a straddle (a combination of a call and a put). By taking the other side, liquidity providers are implicitly short a straddle, suffering losses when volatility spikes. Empirically, we show that short-term reversal strategies, which mimic liquidity creation by buying stocks that go down and selling stocks that go up, have a large negative exposure to volatility shocks. This exposure, together with the large premium investors demand for bearing volatility risk, explains why liquidity creation earns a premium, why this premium is strongly increasing in volatility, and why times of high volatility like the 2008 financial crisis trigger a contraction in liquidity. Taken together, these results provide a new, asset-pricing view of the risks and rewards to financial intermediation.

Keywords: liquidity, volatility, reversals, VIX, variance premium

Suggested Citation

Drechsler, Itamar and Moreira, Alan and Savov, Alexi, Liquidity Creation As Volatility Risk (March 2, 2018). Available at SSRN: https://ssrn.com/abstract=3133291 or http://dx.doi.org/10.2139/ssrn.3133291

Itamar Drechsler (Contact Author)

Wharton School, Department of Finance ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

HOME PAGE: http://https://sites.google.com/site/idrechsl/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Alan Moreira

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

Alexi Savov

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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