Commonality in Liquidity: Transmission of Liquidity Shocks Across Investors and Securities

Posted: 30 Jul 2003

See all articles by Chitru S. Fernando

Chitru S. Fernando

University of Oklahoma - Michael F. Price College of Business

Multiple version iconThere are 2 versions of this paper

Abstract

What are the causes and consequences of commonality in liquidity? We examine this issue using a model of liquidity trading in which liquidity shocks are decomposed into common (systematic) and idiosyncratic components. We show that common liquidity shocks do not give rise to commonality in trading volume. Indeed, trading volume is independent of systematic liquidity risk, and this risk is always priced irrespective of market liquidity. In contrast, idiosyncratic liquidity shocks create liquidity demand and volume, and investors can diversify their risk by trading. Hence, pricing of the risk of idiosyncratic liquidity shocks depends on market liquidity, with idiosyncratic liquidity risk being fully priced only in perfectly illiquid markets. While trading volume increases with the variance of idiosyncratic liquidity shocks, price volatility increases with the variance of both idiosyncratic and systematic liquidity shocks. Surprisingly, our results are largely independent of the number of different securities traded in the market. When asset returns are uncorrelated, there is no transmission of liquidity across assets even when investors experience common liquidity shocks, suggesting that such liquidity shocks may not be the source of commonality in liquidity across assets detected in the literature. However, under limited conditions, more liquid securities can act as substitutes for less liquid securities. Overall, our findings suggest that common factors in liquidity may be the outcome of covariation in investor heterogeneity (e.g. as measured by co-movements in the volatility of idiosyncratic liquidity shocks) rather than of common liquidity shocks. Moreover, we find that different liquidity proxies measure different things, which has implications for future empirical analysis.

JEL Classification: G12, G14, G18, G21

Suggested Citation

Fernando, Chitru S., Commonality in Liquidity: Transmission of Liquidity Shocks Across Investors and Securities. Journal of Financial Intermediation, Vol. 12, pp. 233-254, 2003. Available at SSRN: https://ssrn.com/abstract=419160

Chitru S. Fernando (Contact Author)

University of Oklahoma - Michael F. Price College of Business ( email )

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HOME PAGE: http://faculty-staff.ou.edu/F/Chitru.Fernando-1/

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