Wednesday, May 7, 2014

Liquidity Level or Liquidity Risk

Liquidity has been a pretty hot topic of finance research in the last 10 years and a lot of good work has been done.  Unfortunately, sifting through it can be a little confusing as liquidity can mean a lot of different things in different contexts.

Let's call the liquidity level of a stock, how hard it is to buy and sell.  Can you go to the market and sell as much as you want without moving the price?  Is the price pretty similar whether you want to buy or sell?  Liquidity tends to be measured by either how much trades are moving the price or how large the bid ask spread is.

Let's contrast that with liquidity risk.  We can think of total market liquidity as the average of all the liquidity levels of each individual stocks.  Sometimes the market as a whole is very liquid and sometimes not so much.  The stock market crash of 1987 and the latest financial crisis are examples of large liquidity events.  The average market liquidity dramatically fell.  Liquidity risk is usually measured by a stock returns covariance with total market liquidity.  That is run a regression of market liquidity and stock return.  That estimate (beta) is the stock's liquidity risk.

So, if you are a portfolio manager, which do you care about.  Well, the liquidity level of a portfolio may matter if your strategy requires a lot of turnover and trading, a high liquidity level will make your strategy more expensive.  But if you are worried about liquidity events, events where you may have to sell when the market is tanking, then you really care about liquidity risk.

A recent paper by Lou and Sadka shows that it's liquidity risk that mattered in the financial crisis of 2009:

The liquid stocks that have low liquidity risk do as well as the illiquid stocks with low liquidity risk, and the high liquidity risk stocks do worse than the low liquidity risk stocks whether the stocks tend to be liquid or not.

High liquidity risk stocks become more illiquid when the market becomes more illiquid.  Even if usually they have a lot of liquidity, that liquidity dries up in bad times.

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