Ebook Some Hypotheses on Commonality in Liquidity: New Evidence from the Chinese Stock Market
The concept of ‘commonality in liquidity’ has been popularized by Chordia et al. (2000) and pertains to the phenomenon of time-series movements in liquidity due to common underlying determinants across securities. Commonality refers to the proposition that an individual firm’s liquidity is at least partly determined by market-wide liquidity. Its empirical manifestation is the co-movement between variations in individual stock liquidity and variations in market and industry-wide liquidity, as found by Chordia et al. (2000).
Understanding commonality in liquidity is crucial for a number of reasons. First, a strand of the literature has documented the existence of a strong relationship between ownership structure and individual firm liquidity (Sarinet al., 2000 and Lipson, 2003; among others). Furthermore, the relationship between commonality in liquidity and ownership structure is more important because Chinese firms tend not to fully disclose material changes in their business conditions, and published statements do not always meet international accounting standards (Chan et al., 2008). Most of Chinese listed companies are state-owned enterprises controlled by local governments which prefer employing small auditors (Wang et al. 2008). Lack of quality auditing can potentially have adverse effects on ownership structure, which can result in loss of credibility particularly to outside investors (see Fan and Wong, 2002). As a result, a system change of liquidity will induce significant changes of ownership structure which can be reflected by the changes in a firm’s prices and the changes in a firm’s liquidity, such as bid-ask spread, depth and turnover rate.
Second, given that liquidity is a determinant of asset prices, commonality in liquidity will have an impact on asset prices. However, this is largely ignored by conventional asset pricing models. Fundamental changes are, therefore, required for these models to incorporate this effect. Future models will not only have to explain the impact of individual liquidity on an asset’s price, but must also consider common determinants of liquidity; for studies that have considered commonality in liquidity in asset pricing models, see, inter alia, Pastor and Stambaugh (2003), Acharya and Pedersen (2005), and Korajczyk and Sadka (2008). For practical investment, a better understanding of the dynamics of liquidity, both within and across markets, could help investors design improved trading strategies. Findings about the properties of common determinants will also help investors to decide on their liquidity exposures. With an improved knowledge of factors that influence liquidity, investor confidence will increase, leading to more efficient corporate resource allocation (Chordia et al., 2003).
Third, for market participants, one of the issues is whether market liquidity is priced on the stock market, or whether a liquidity risk factor enters the stochastic discount factor. Given that individual stock liquidity is at least partly driven by common determinants, shocks to these common factors tend to generate market-wide effects. If asset returns and market liquidity are correlated, the source of common liquidity effects could constitute a non-diversifiable risk factor. In other words, systematic liquidity variation is non-diversifiable, and so is a priced risk factor. Thus, investors holding such assets will demand a systematic liquidity premium to bear the risk (Fujimoto, 2003). As such, commonality in liquidity also poses a problem to diversification strategies that rely on picking stocks that do not correlate with returns (Domowitz and Wang, 2002).
Fourth, commonality in liquidity is also important to central bankers and regulators. As a market risk factor that is non-diversifiable, it is naturally a policy concern. By its very nature, shocks to commonality will have market-wide effects and hence affect the functioning of the financial market as a whole. In more serious cases, a financial crisis can be triggered by shocks to liquidity commonality. Fernando and Herring (2003) show that common liquidity shocks may precipitate a shift in investors’ beliefs about the market, which in turn could lead to a market collapse. In fact, the simultaneous decline in liquidity across several markets was a major factor in the Asian financial crisis in 1997-1998.
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