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Liquidity and Volatility


  • Itamar Drechsler
  • Alan Moreira
  • Alexi Savov


Liquidity provision is a bet against private information: if private information turns out to be higher than expected, liquidity providers lose. Since information generates volatility, and volatility co-moves across assets, liquidity providers have a negative exposure to aggregate volatility shocks. As aggregate volatility shocks carry a very large premium in option markets, this negative exposure can explain why liquidity provision earns high average returns. We show this by incorporating uncertainty about the amount of private information into an otherwise standard model. We test the model in the cross section of short-term reversals, which mimic the portfolios of liquidity providers. As predicted by the model, reversals have large negative betas to aggregate volatility shocks. These betas explain their average returns with the same risk price as in option markets, and their predictability by VIX in the time series. Volatility risk thus explains the liquidity premium among stocks and why it increases in volatile times. Our results provide a novel view of the risks and returns to liquidity provision.

Suggested Citation

  • Itamar Drechsler & Alan Moreira & Alexi Savov, 2020. "Liquidity and Volatility," NBER Working Papers 27959, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:27959
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    Cited by:

    1. Brad M. Barber & Xing Huang & Terrance Odean & Christopher Schwarz, 2022. "Attentionā€Induced Trading and Returns: Evidence from Robinhood Users," Journal of Finance, American Finance Association, vol. 77(6), pages 3141-3190, December.
    2. Switzer, Lorne N., 2023. "Circumventing SEC Rule 201 short sale restrictions with options," Finance Research Letters, Elsevier, vol. 55(PB).

    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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