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Market Liquidity and Flow-driven Risk

  • Prachi Deuskar
  • Timothy C. Johnson
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    Using a unique dataset of trades and limit orders for S&P 500 futures, we decompose the aggregate risk into a component driven by the impact of net market orders and a component unrelated to net orders. The first component--flow-driven risk--is large, accounting for approximately 50% of market variance, and it is not transient. This risk represents the joint effect of net trade demand and the price impact of that demand--i.e., illiquidity. We find that flows are largely unpredictable, and lagged flows have no price impact. Flow-driven risk is time varying because price impact is highly variable. Illiquidity rises with market volatility, but not with flow uncertainty. Net selling increases illiquidity, which amplifies downside flow-driven risk. The findings are consistent with flow-driven shocks resulting from fluctuations in aggregate risk-bearing capacity. Under this interpretation, investors with constant risk tolerance should trade against such shocks (i.e., "supply liquidity") to achieve substantial utility gains. Quantitatively accounting for the scale of flow-driven risk poses a major challenge for asset pricing theory. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

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    Article provided by Society for Financial Studies in its journal Review of Financial Studies.

    Volume (Year): 24 (2011)
    Issue (Month): 3 ()
    Pages: 721-753

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    Handle: RePEc:oup:rfinst:v:24:y:2011:i:3:p:721-753
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