Ruslan Goyenko

Stock and Bond Market Liquidity: A Long-Run Empirical Analysis

This paper establishes liquidity linkage between stock and Treasury bond markets. There is a lead-lag relationship between illiquidity of the two markets and bidirectional Granger causality. The effect of stock illiquidity on bond illiquidity is consistent with flight-to-quality or flight-to-liquidity episodes. Monetary policy impacts illiquidity. The evidence indicates that bond illiquidity acts as a channel through which monetary policy shocks are transferred into the stock market. These effects are observed across illiquidity of bonds of different maturities and are especially pronounced for illiquidity of short-term maturities. The paper provides evidence of illiquidity integration between stock and bond markets.

The Term Structure of Bond Market Liquidity and Its Implications for Expected Bond Returns

Previous studies of Treasury market illiquidity span short time periods and focus on particular maturities. In contrast, we study the time series of illiquidity for different maturities over an extended period of time. We also compare time-series determinants of on-the-run and off-the-run illiquidity. Illiquidity increases and the difference between spreads of long- and short-term bonds significantly widens during recessions, suggesting a “flight to liquidity,” wherein investors shift into the more liquid short-term bonds during economic contractions. Macroeconomic variables such as inflation and federal funds rates forecast off-the-run illiquidity significantly but have only modest forecasting ability for on-the-run illiquidity. Bond returns across maturities are forecastable by off-the-run but not on-the-run bond illiquidity. Thus, off-the-run illiquidity, by reflecting macro shocks first, is the primary source of the liquidity premium in the Treasury market.

Stock and Bond Pricing with Liquidity Risk

The paper tests the liquidity linkage between the stock and Treasury bond markets and its implications for asset pricing. We find that liquidity has a cross-market effect, which we attribute to trading activity across markets. We show that stock returns contain not only an illiquidity premium of the stock market as has been documented in the literature, but also an illiquidity premium of the bond market. A difference of 10 percentage points in the exposure to bond illiquidity risk between two stocks translates into a difference of 7 to 9 percent in their expected returns per year. Bond returns also contain an illiquidity premium of both the stock and bond markets. We document that the illiquidity of the stock market and/or unexpected shock to the bond market illiquidity dominate the momentum factor in the Carharts (1997) four-factor model. We introduce a five-factor model. Finally, we test the cross-market liquidity effect within an arbitrage-free affine joint stock and bond pricing model with stock and bond market liquidity included in the vector of state variables, and find support for the model. Under the models restrictions, a 10 percentage points change in the stock illiquidity leads to 1.4% change in the risk free rate per year. Overall, the paper contributes to the integration between stock and bond markets.

Treasury Bond Illiquidity and Global Equity Returns

In this study, using data from 46 markets and a 34-year time period, we examine the impact of the illiquidity of U.S. Treasuries on global asset valuation. We find that it predicts equity returns in both developed and emerging markets. This predictive relation remains intact after controlling for various worldand country-level variables. Asset pricing tests further reveal that bond illiquidity is a priced factor even in the presence of other conventional risks. Since the illiquidity of Treasuries is known to reflect monetary and macroeconomic shocks, our results suggest that it can be considered a proxy for aggregate worldwide risks.

Illiquidity Premia in the Equity Options Market

Standard option valuation models leave no room for option illiquidity premia. Yet we find the risk-adjusted return spread for illiquid over liquid equity options is

Options Illiquidity: Determinants and Implications for Stock Returns

3.4\%

Treasury Liquidity, Funding Liquidity and Asset Returns

per day for at-the-money calls and

Do Liquidity Measures Measure Liquidity

2.5 \%

Mutual Fund's R^2 as Predictor of Performance

for at-the-money puts. These premia are computed using option illiquidity measures constructed from intraday effective spreads for a large panel of U.S. equities, and they are robust to different empirical implementations. Our findings are consistent with evidence that market makers in the equity options market hold large and risky net long positions, and positive illiquidity premia compensate them for the risks and costs of these positions. Received September 25, 2012; editorial decision September 17, 2017 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

The Term Structure of Bond Market Liquidity

We study the determinants of individual options bid-ask spreads using proprietary intraday transactions data for the large cross-section of firms over an extended time period. We find that (i) hedging by options market makers plays the biggest role in determining spreads across all options categories, and rebalancing costs substantially dominate initial delta-hedge costs; (ii) options order imbalances associated with exogenous net demand shocks have independent impact on options bid-ask spreads which is comparable in economic magnitudes to delta-hedge costs; (iii) information asymmetry contributes to wider bid-ask spreads only for out-of-the money contracts, however, in economic magnitudes this effect is similar to net-demand shocks or delta-hedging costs. Overall, the results help understanding options market microstructure which differs substantially from the market of underlying equities.