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Evaporating Liquidity

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  • Nagel, Stefan

Abstract

The returns of short-term reversal strategies in equity markets can be interpreted as a proxy for the returns from liquidity provision. Analysis of reversal strategies shows that the expected return from liquidity provision is strongly time-varying and highly predictable with the VIX index. Expected returns and conditional Sharpe Ratios increase enormously along with the VIX during times of financial market turmoil, such as the financial crisis 2007-09. Even reversal strategies formed from industry portfolios (which do not yield high returns unconditionally) produce high rates of return and high Sharpe Ratios during times of high VIX. The results point to withdrawal of liquidity supply, and an associated increase in the expected returns from liquidity provision, as a main driver behind the evaporation of liquidity during times of financial market turmoil, consistent with theories of liquidity provision by financially constrained intermediaries.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8775.

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Date of creation: Jan 2012
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Handle: RePEc:cpr:ceprdp:8775

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Keywords: Financial Crisis; Liquidity; Return Reversals;

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Cited by:
  1. Lasse Heje Pedersen, 2009. "When Everyone Runs for the Exit," NBER Working Papers 15297, National Bureau of Economic Research, Inc.
  2. Chen, Haojun & Maher, Daniela, 2013. "On the predictive role of large futures trades for S&P500 index returns: An analysis of COT data as an informative trading signal," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 27(C), pages 177-201.
  3. Zhi Da & Qianqiu Liu & Ernst Schaumburg, 2011. "Decomposing short-term return reversal," Staff Reports 513, Federal Reserve Bank of New York.
  4. Brogaard, Jonathan & Hendershott, Terrence & Riordan, Ryan, 2013. "High frequency trading and price discovery," Working Paper Series 1602, European Central Bank.
  5. Stefan Nagel, 2014. "The Liquidity Premium of Near-Money Assets," NBER Working Papers 20265, National Bureau of Economic Research, Inc.

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