Ebook Stock and Bond Pricing with Liquidity Risk
Since Amihud and Mendelson (1986, 1989) proposed that liquidity affects asset prices because investors require compensation for bearing transaction costs, asset pricing research has found consistent support for this proposition in different asset classes. Expected excess returns on stocks contain an illiquidity premium in the stock market (Amihud, 2002), and excess yield partly reflects differences in the liquidity of bonds of different maturities in the Treasury market (Amihud and Mendelson, 1991; Kamara, 1994). In both asset classes, liquidity is a source of systematic risk with less liquid securities having higher returns.
However, the studies of the liquidity effect on asset returns are focused principally either on equity or Treasury bond markets. This is surprising given the theoretical and empirical literature on the asset pricing kernel which should price all risky assets. This paper tests whether liquidity has a cross-market effect. Specifically, we test whether stock liquidity affects bond returns and whether bond liquidity has an impact on stock prices. If this is the case, we expect that stock and bond markets have similar sources of liquidity. Among the sources of liquidity advocated by the market microstructure literature are trading activity, volatility and prices (Benston and Hagerman, 1974; Stoll, 1978).
The source of cross-market effects from trading may be the result of portfolio managers shifting wealth between stocks and Treasuries (Ammann and Zimmermann, 2001; Fox, 1999). When there is a negative shock in the stock market, funds may flow into the “safe haven” of the Treasury bond market (“flight to quality”), as investors substitute safe assets for risky assets (Gulko (2002)). The resulting outflow from stocks into Treasury bonds stimulates trading across the two markets. Also continuous changes in the anticipated rate of inflation, news about company earnings, and Federal Reserve policy changes are some of the market influences that drive investors to switch from bonds to stocks or stocks to bonds.
In any other situation, bond traders continually compare interest rate yields for bonds with those for stocks. If stock yields for the S&P 500 as a whole are the same as bond yields, investors prefer the safety of bonds. Bond prices then rise and stock prices decline as a result of money movement. As bond prices trade higher, due to their popularity, the effective yield for a given bond will decrease because its face value at maturity is fixed. As effective bond yields decline further, bond prices top out and stocks begin to look more attractive, although at a higher risk.
In derivatives trading, replicating (or hedging) portfolio requires trading in the underlying asset and the risk-free bond. For example, for traders in options on the S&P 500 Index maintaining a hedge will require trading in the stock market, the index itself, and in the bond market. Re-balancing a hedging portfolio will lead to trading in the two markets.
Volatility can effect liquidity in both markets by altering the inventory risk born by market making agents (Ho and Stoll, 1983; O’Hara and Oldfield, 1986). Indeed, the literature has found strong volatility linkages between the two markets (Fleming, Kirby and Ostdiek, 1998). Further, Chordia, Sarkar and Subrahmanyam (2005) find cross-market dynamics flowing from volatility to liquidity. Prior research also identifies a close relationship between volatility and information flow (Ross, 1989). Taken together, these findings suggest that liquidity reflects cross-market information spillover. As such, this effect will be picked up via trading activity across markets.
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