A substantial body of research demonstrates that, all else equal, investors prefer stocks that are liquid and that transparency has the potential to improve liquidity (for a summary see, Amihud, Mendelson and Pedersen (2005)). However, the concern for an investor is broader than simply the average level of liquidity because what matters is the liquidity at the time they choose to transact. Investors prefer firms with relatively predictable liquidity because they are able to better anticipate the likely trading costs associated with closing a position at the time they make the initial purchase decision. To the extent a stock’s liquidity is highly variable, it increases the uncertainty attached to a position and limits a potential investor’s flexibility. For example, investors who need to reduce overall exposure may face the alternative of either selling shares at substantially below intrinsic value due to price pressure or switching to liquidating other positions.
In extreme cases, stocks may be subject to periods where liquidity suddenly dries up, effectively eliminating the opportunity for a trader to enter or exit a position at all. For example, Moorthy (2003) discusses, from the perspective of a portfolio manager, the possibility of “liquidity black holes” in equity markets in which liquidity freezes in the absence of investors willing to take the other side of positions and fund managers faced with redemptions are forced to either offload positions at fire-sale prices or unbalance their portfolios by selling their most liquid securities.
Not only does the variability of liquidity matter, but its timing matters as well. Liquidity is of special concern if it tends to dry up at inopportune times. If liquidity in a given stock is highly correlated with liquidity in other stocks or with market returns, it is likely to be expensive to sell at exactly the time the investor wants to liquidate the position. Research such as Brunnermeier and Pedersen (2009) (hereafter referred to as ‘BP (2009)’), discussed in more detail in the next section, suggests that firm-level liquidity will naturally be positively correlated with overall market liquidity and with market returns because traders’ ability to provide liquidity is typically a function of the availability of funds (their capital and the margins charged by their financiers), which can induce co-movement in liquidity across stocks as well as co-movement between firm-specific liquidity and market returns.
Acharya and Petersen (2005) decompose the CAPM beta to show that cost of capital is a function of the covariance between firm liquidity and both market returns and market liquidity. They provide empirical evidence that U.S. stocks that maintain a relatively constant level of liquidity when overall markets become illiquid, or when stock returns are negative, enjoy a lower cost of capital because investors are willing to pay more for shares if they expect to be able to exit their positions at a relatively low cost during these periods.
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Transparency and Liquidity Uncertainty in Crisis Periods
