Illiquidity shocks and the comovement between stocks

new evidence using smooth transition

Patricia Chelley-Steeley, Neophytos Lambertides, Christos S. Savva

Research output: Contribution to journalArticle

Abstract

This paper extends the smooth transition conditional correlation model by studying for the first time the impact that illiquidity shocks have on stock market return comovement. We show that firms that experience shocks that increase illiquidity are less liquid than firms that experience shocks that decrease illiquidity. Shocks that increase illiquidity have no statistical impact on comovement. However, shocks that reduce illiquidity lead to a fall in comovement, a pattern that becomes stronger as the illiquidity of the firm increases. This discovery is consistent with increased transparency and an improvement in price efficiency. We find that a small number of firms experience a double illiquidity shock. For these firms, at the first shock, a rise in illiquidity reduces comovement while a fall in illiquidity raises comovement. The second shock partly reverses these changes as a rise in illiquidity is associated with a rise in comovement and a fall in illiquidity is associated with a fall in comovement. These results have important implications for portfolio construction and also for the measurement and evolution of market beta and the cost of capital as it suggests that investors can achieve higher returns for the same amount of market risk because of the greater diversification benefits that exist. We also find that illiquidity, friction, firm size and the pre-shock correlation are all associated with the magnitude of the correlation change.

Original languageEnglish
Pages (from-to)1-15
Number of pages15
JournalJournal of Empirical Finance
Volume23
Early online date13 Apr 2013
DOIs
Publication statusPublished - Sep 2013

Fingerprint

Smooth transition
Comovement
Illiquidity
Transparency
Diversification benefits
Market risk
Friction
Firm size
Cost of capital
Investors
Price efficiency
Stock market returns
Portfolio construction
Conditional correlation

Keywords

  • comovements
  • smooth transition model
  • stock liquidity

Cite this

Chelley-Steeley, Patricia ; Lambertides, Neophytos ; Savva, Christos S. / Illiquidity shocks and the comovement between stocks : new evidence using smooth transition. In: Journal of Empirical Finance. 2013 ; Vol. 23. pp. 1-15.
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Illiquidity shocks and the comovement between stocks : new evidence using smooth transition. / Chelley-Steeley, Patricia; Lambertides, Neophytos; Savva, Christos S.

In: Journal of Empirical Finance, Vol. 23, 09.2013, p. 1-15.

Research output: Contribution to journalArticle

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