In the event of a large market decline, we often observe that the liquidity in financial markets also dries up. Why does this happen? Professor Allaudeen Hameed and his co-authors investigate the impact of fall in aggregate market valuations on various dimensions of liquidity and find that liquidity is significantly affected by large market declines.

Liquidity refers to the ability to buy or sell a security quickly without significantly impacting its price.

For example, if a seller needs to absorb a significant loss in value in order to sell an asset immediately, then the asset is relatively illiquid.

In many active stock markets, market makers (or other specialists) provide liquidity by accommodating trades initiated by buyers and sellers.

Although stock market investments are more liquid than investments in real estate, Prof Allaudeen and his co-authors observed that liquidity in stock markets does go through periodic changes.

For example, a rapid drop in aggregate market prices may lead to a large number of investors wanting to get out of their risky investments. This will cause panic selling.

The large selling pressure (without a commensurate buying demand) for these risky stocks leads to big price impact when they are traded in the equity markets (i.e. low liquidity).

In addition, a dramatic decrease in the market valuation of equities may also trigger capital tightness. This in turn makes it most difficult for market makers to provide liquidity, since liquidity provision also requires (risk) capital.

What Prof Allaudeen and his team found interesting was that when large market declines in equities, there was an increased imbalance in buy and sell orders. There was also a flow of funds out of the equity mutual funds (demand for liquidity effects) and effects of reduction in supply of liquidity due to capital constraints in the funding market.

"Market makers and other financial intermediaries are liquidity suppliers to the market. When they withdraw from the market due to capital constraints, and have to unwind their long positions in equities, they become demanders of liquidity," explained Prof Allaudeen.

These, and other findings were discussed in his working paper, Stock Market Declines and Liquidity, co-authored with fellow NUS Business School faculty Assistant Professor Kang Wenjin and Professor S.Viswanathan of Fuqua School of Business, Duke University.

Return to liquidity provision

Does the return to liquidity provision change with respect to changes in asset values?

Prof Allaudeen and team used the idea that short-term stock price reversals following heavy trading reflect compensation for supplying liquidity, to devise a simple equity trading strategy.

They show that their trading strategies based on limit-order yield statistically and economically significant risk-adjusted average returns of between one and two percent per week.

And this is during periods of large market declines.

These findings imply that the returns to supplying liquidity rises significantly following periods of large fall in aggregate stock market values, consistent with the prediction that the drop in liquidity is related to supply effects.

The Head of Finance of NUS Business School also pointed out that on average, illiquidity effect in the equity market lasts between one to two weeks.

"We interpret our results as indicative of the presence of supply effects arising from capital constraints even in liquid markets like US equities, although capital does flow into the market fairly quickly," summed up Prof Allaudeen.

Professor Allaudeen Hameed is Professor of Finance and Head of NUS Business School's Department of Finance. He received his doctorate in finance from The University of North Carolina at Chapel Hill. His research interests include return-based trading strategies, and liquidity in financial markets. The above article is an adaptation from his working paper "Stock Market Declines and Liquidity".

Back to e-Newsletter