Liquidity can be described as the ability to trade a large number of investments quickly, at low costs and when you want to.
Because it is a priced risk, liquidity and its associated price effects are an important aspect of financial markets.
In illiquid markets, such as the private equity market, discounts are large and pervasive. Publicly traded equity, however, is generally more liquid. As a result, it’s important to understand the size of the liquidity premium associated with publicly traded stocks, and whether it’s economically significant.
Of particular interest to investors is that over the last 40 years, we’ve seen many technological innovations (such as high-frequency trading) and regulatory changes (such as decimalization) that may have contributed to improving liquidity in financial markets by lowering bid/offer spreads.
The dramatic expansion of the hedge fund industry, which now has approximately $3 trillion in assets under management, may also have had an impact on market liquidity. It’s possible that hedge funds, many of which act as long-horizon traders and thus incur relatively small transaction costs, might have arbitraged away (or at least reduced the size of) the liquidity premium by purchasing illiquid stocks and short-selling liquid stocks.
Financial innovation, in the form of low-cost index funds and ETFs, may also play a role in affecting the liquidity premium. The presence of such instruments allows investors to buy and sell illiquid assets indirectly, lowering the sensitivity of returns to liquidity.
Investors are able to obtain illiquid stocks indirectly for very low transaction costs, prolonging the investment horizon of the marginal investor that holds illiquid stocks and thereby reducing the sensitivity of returns to liquidity.
Premium Put To Test
How have all these developments impacted the liquidity premium? Have they caused the liquidity premium to shrink, or even vanish? In their study, “The Diminishing Liquidity Premium,” Azi Ben-Rephael, Ohad Kadan and Avi Wohl sought answers to these questions.
Their paper, which appears in the April 2015 issue of the Journal of Financial and Quantitative Analysis, used a data set incorporating stocks traded on all three major exchanges. For NYSE stocks, the sample period is from 1931 through 2011; for AMEX stocks, the sample period is from 1964 through 2011; and for Nasdaq stocks, the sample period is from 1986 through 2011.
2 Types Of Liquidity Premiums
The authors begin by explaining that there are two types of liquidity premiums. The first they refer to as a characteristic liquidity premium, which is associated with the transaction costs of trading in the security.
The second is a systematic liquidity premium, which is associated with the sensitivity of stock returns to shocks in market liquidity. It’s the risk that a firm’s stock price will decline in conditions where market liquidity is low. The authors noted that the two types of premiums aren’t necessarily related and may exhibit different trends.
In analyzing liquidity’s influence, the authors used three measures, each of which captures a different aspect of liquidity. The first is a measure of price impact, calculated as the annual average of daily absolute return to dollar volume. The second is a measure of the bid/offer spread. The third measure combines both these facets of liquidity and measures the price impact of the spread to annual dollar volume.