Empirical Asset Pricing
Market Microstructure
Macroeconomics

Investments
International Finance
Corporate Finance
Macroeconomics

Financial Economics and International Economics (Oral), 2000
Microeconomic and Macroeconomic Theory (Written), 1999

The Role of Systematic Liquidity in Financial Markets

Professor William N. Goetzmann (Chair)
Professor Matthew Spiegel
Professor George J. Hall

May 2004

Ph.D., Economics (Financial Economics), Yale University, expected May 2004
M.Phil., Economics, Yale University, December 2001
M.A., Economics, Yale University, May 2001
B.A. (Honours), Economics, Queen’s University, Canada, June 1998, Medal in Economics
B.A. (General), Economics, Queen’s University, Canada, June 1996, Medal in General B.A. Program

Western Finance Association
     Ph.D. Student Travel Grant, June 2003
Yale University
     Dissertation Fellowship, Fall 2003
     Department of Economics Summer Research Fellowship, Summer 2002
     Ryoichi Sasakawa Young Leaders Fellowship Fund, Fall 2001
     Graduate Student Fellowship, 1998-2001
Queen’s University
     Medal in Economics/Chancellor C.A. Dunning Prize in Economics, June 1998
     Edith Whyte Memorial Scholarship in Economics, September 1997
     Medal in General B.A. Program, June 1996
     Dean’s Special Award, September 1995
     George and Mary Louise Patton Memorial Scholarship, September 1995
     Gordon and Myrtle Adams Scholarship, September 1995
     William Mitchell Silliman Scholarship, September 1994
     Dean’s Honour List, August 1994, August 1995, and August 1996
     Annie Bentley Lillie Prize in First Year Calculus, June 1994

Teaching Assistant, Yale University
     Intermediate Macroeconomics, Professor George J. Hall, Spring 2003
     Introductory Macroeconomics, Professors Gerald D. Jaynes and William D. Nordhaus, Fall 2003
     Financial Markets, Professor Robert J. Shiller, Spring 2002
     International Trade, Professor Philip I. Levy, Spring 2001
     International Finance, Professor Giancarlo Corsetti, Fall 2000

Research Assistant, Professor Koichi Hamada, Department of Economics, Yale University, 1999
     Project commissioned by the Japanese Ministry of Economy, Trade, and Industry.
     Analyzed macroeconomic effects of oil price fluctuations in Asia.

Working Papers, Yale University
     “Macroeconomic Sources of Systematic Liquidity,” October 2003
     “Liquidity and Expected Market Returns: An Alternative Test,” October 2003
     “Liquidity and Conditional Heteroscedasticity in Stock Returns,” with Masahiro Watanabe, October 2003
     “Liquidity, Market Sentiment, and Momentum,” March 2003
     “Decimalization and Market Liquidity,” April 2002
     “Liquidity Comovement Under Different Trading Mechanisms,” May 2001

Conferences
     Western Finance Association, Los Cabos, Mexico, June 2003
          “Macroeconomic Sources of Systematic Liquidity”
     Northern Finance Association, Banff, Canada, September 2002
          “Decimalization and Market Liquidity”
          “Liquidity Comovement Under Different Trading Mechanisms”
Seminars
     Yale School of Management Finance Seminar, October 2003
          “Macroeconomic Sources of Systematic Liquidity”

Discussant
     Northern Finance Association, Banff, Canada, September 2002

American Finance Association, since 2003

The recent identification of commonality in liquidity by Chordia, Roll, and Subrahmanyam (2000), Hasbrouck and Seppi (2001), and Huberman and Halka (2001) has brought increasing attention to the role of systematic liquidity in financial markets. Among the questions that this finding has raised, two have been particularly important and remain the subjects of ongoing research. First, what are the causes of time variation in market-wide liquidity? Second, what effect does it have on asset returns?

Much of the recent work has focused on the second question and there is now some evidence that the variation in market-wide liquidity is indeed an important factor in explaining the cross-section of stock returns (Acharya and Pedersen (2003) and Pastor and Stambaugh (2003)) and the time-series of aggregate returns (Amihud (2002) and Jones (2002)). My dissertation extends this line of research and examines the intertemporal relation between market liquidity and market returns (Chapter II) as well as the liquidity-volatility relation for market and individual securities (Chapter III).

Despite the progress in understanding the effects of systematic liquidity, it remains largely unknown what factors are responsible for the time variation in liquidity. This is particularly true for liquidity dynamics over long horizons, as traditional research in market microstructure typically deals with transaction-level liquidity dynamics. The existence of liquidity comovement across individual stocks suggests that some underlying economic forces are responsible for the dynamics of the systematic component of liquidity. Understanding this mechanism is important given that market liquidity has pervasive effects on investors’ overall welfare. Based on the inventory model of liquidity, changes in economic fundamentals may alter the perceived risk of holding inventory across stocks and affect market-wide liquidity. My dissertation also investigates whether macroeconomic factors are important in explaining the time variation in liquidity (Chapter I).

Chapter I: Macroeconomic Sources of Systematic Liquidity

This chapter investigates macroeconomic sources of time variation in liquidity. Using a vector autoregression approach, I examine the dynamic relation between market liquidity and various macroeconomic factors over the past four decades. The results show that their intertemporal relation has changed dramatically over time and that macroeconomic influence on liquidity is stronger before the mid 1980’s when business cycle dynamics is more volatile. During the first half of the sample, inflation and monetary policy are particularly important in explaining the liquidity’s variation. Market liquidity improves significantly for an extended period of time in response to a positive shock in nonborrowed reserves and negative shocks in supply-side inflation and the federal funds rate. The macroeconomic shocks also affect variables such as market return, volatility, and share turnover that are found to be other important drivers of liquidity. The results therefore suggest that macroeconomic factors not only influence liquidity directly, but also indirectly through their effects on these market variables. During the latter half of the sample period, market return, volatility, and share turnover remain the only significant determinants of liquidity, but their effects are small compared to those in the earlier period. Overall, market liquidity has become more resilient to both market-level and economy-wide shocks.

Chapter II: Liquidity and Expected Market Returns: An Alternative Test

This chapter studies the effect over time of market liquidity on excess market returns using four different proxies for aggregate liquidity that are found to have significant effects on the cross-section of stock returns. In contrast to past empirical findings, there is only weak evidence of stock return predictability using these market liquidity measures. The predictive ability of liquidity remains limited over different forecast horizons and different sample periods. However, the negative contemporaneous effect of illiquidity shocks on excess market returns is significant and robust. The results show that the excess market return responds significantly to various forms of illiquidity shocks simultaneously even after taking into account the effect of market volatility. There is also some evidence of asymmetry in market return’s response to illiquidity shocks across different economic states. The negative illiquidity-return relation is strong during recessions and when the short-term interest rate is high. This suggests that investors depress prices more in response to illiquidity shocks when they anticipate higher market illiquidity to accompany sluggish economy where they face greater need to liquidate their financial assets.

Chapter III: Liquidity and Conditional Heteroscedasticity in Stock Returns
(Joint with Masahiro Watanabe)

This chapter finds a significant positive relation between illiquidity and conditional variance of stock returns, both at the individual and aggregate levels.  For each of the largest two hundred stocks on the NYSE and NASDAQ, we estimate a GARCH model in which share turnover and proportional spread enter the conditional variance equation.  We find that, for 75% of the stocks examined, proportional spread is a significant and positive determinant of conditional heteroscedasticity after orthogonalization against share turnover and return.  Illiquidity has an even stronger positive effect on the variability of aggregate market return.  In support of these findings, we present a simple market microstructural model in which conditional return variance is a positive and nonlinear function of stochastic Kyle's lambda.