Term Paper Liquidity and Asset Pricing

Institute for Research in Economic Evolution Prof. Thomas Gehrig, Ph.D. University of Freiburg

submitted by: Sebastian Braun supported by: Dipl.- Math. Dipl.- Vw. Jrg Bleile 01/08/2010 Freiburg

Index Index.....................................................................................................................II 1 2 Introduction ................................................................................................... 1 Liquidity - a closer look................................................................................ 2

2.1 2.2 2.3 2.4 Macroeconomic liquidity ............................................................................................ 2 Funding liquidity ......................................................................................................... 2 Market liquidity........................................................................................................... 2 The dimensions of liquidity......................................................................................... 3 2.4.1 The time dimension of liquidity........................................................................ 3 2.4.2 The price dimension of liquidity....................................................................... 3 2.5 Depth, breadth and resiliency of markets .................................................................... 4 2.6 Measuring market liquidity ......................................................................................... 4

3 4 5

The value of liquidity .................................................................................... 5 From CAPM to a Liquidity Asset Pricing Model ...................................... 6 The LAPM ..................................................................................................... 8
5.1 5.2 5.3 5.4 Risk-free rate of interest .............................................................................................. 8 Illiquidity cost.............................................................................................................. 8 Risk premium .............................................................................................................. 9 The risk betas............................................................................................................... 9 5.4.1 Standard market beta....................................................................................... 10 5.4.2 The three liquidity risks .................................................................................. 10 5.4.2.1 Commonality in liquidity beta ......................................................... 10 5.4.2.2 Return exposure to market liquidity beta......................................... 10 5.4.2.3 Liquidity exposure to market return beta......................................... 11 5.5 Liquidity Adjusted CAPM in gross return ................................................................ 11

6 7

Empirical back testing of the model.......................................................... 12 Conclusion.................................................................................................... 13

II

Introduction

The aim of this paper is to integrate liquidity as a fundamental determinant of investment decisions. It wants to sensibilize for the fact that liquidity is a fundamental factor that influences the pricing behaviour of assets. Through the drying out of whole markets during the recent financial crises and the following liquidity wave as a result of the low interest policy it is even more interesting to observe the influence of liquidity on asset pricing. Handa and Schwarz (1996) comment on the influence on liquidity: Investors want three things from the markets: liquidity, liquidity, liquidity.1 Already in 1936 Keynes referred with his Theory of liquidity preference to a correlation between liquidity and asset pricing.2 More recent models try to integrate the influence of liquidity into already established financial models. In the focus of this paper is the liquidity adjusted Asset Pricing Model (LAPM) which Acharya and Pedersen (2005) derivated from the Standard CAPM. From the LAPM important conclusions for the pricing puzzle can be drawn. Illiquidity of an asset is a risk investors want to be compensated for with a return premium. Vice versa they accept a higher price for an asset if it is liquid. The LAPM allows to value illiquidity and helps to decompose the influence of liquidity in the following components: (i) the level of liquidity; (ii) the commonality in liquidity risk; (iii) the return exposure to market liquidity risk and (iv) the liquidity exposure to market return risk. In an empirical back testing the LAPM has a better significance than the Standard CAPM in form of R2. In this paper first several definitions of liquidity will be distinguished. Then it is resolved that illiquidity of an asset must be understood as a risk. After that it is shown how liquidity of assets can be measured. Furthermore it will be analysed in which way liquidity influences investment decisions respectively why investors prefer liquid assets c.p. to less liquid assets. Additionally it will be shown how a liquidity factor can be integrated into the CAPM. Next a liquidity adjusted CAPM is derivated and finally the previous results will be tested for evidence.

1 2

Handa/Schwarz (1996), page 44 Keynes (1936), The General Theory of Employment, Interest and Money

Liquidity - a closer look

In scientific studies the term liquidity is used in a variety of different contexts. In order to analyse the relationship between liquidity and asset prices it is first of all necessary to define and classify the term liquidity. This also seems to be relevant for the integration of this paper into the liquidity literature. On closer examination the term liquidity is used as follows: 2.1 Macroeconomic liquidity

The term macroeconomic liquidity describes the availability of cash in an economy. Often it is used as a synonym for the monetary base. Macroeconomic liquidity is influenced through the policy of the central banks. Determinating factors are (among others) interest rates, credit conditions, the money supply and credit aggregates. 2.2 Funding liquidity

The term funding liquidity describes the possibility to obtain funding for investments, which enables traders to act as market makers. In business the term refers to a company's ability to meet its obligation when they fall due. If a firm is unable to meet its obligation in time, the company is in danger of insolvency. 2.3 Market liquidity

A market is considered as liquid if an asset can be sold immediately within the market hours without causing movement in price and with minimum loss of value. Other criteria are willing investors who want to buy and sell and the probability that the next trade can be executed at a price equal to the last one.3 Although the term liquidity is used in different contexts, the different types of liquidity are closely connected. So it seems to be intuitive that, the macroeconomic definition of liquidity as a synonym for the monetary base, as well as funding liquidity are determinative factors of market liquidity.4 The term liquidity of an asset as used in this paper is largely congruent with the definition of market liquidity. So an asset has perfect liquidity if it can be bought or sold immediately without a premium or discount.

3 4

Close to Grossman/Miller (1988) Liquidity and market structure For evidence see Brunnermeier/Pedersen (2008), Market Liquidity and Funding Liquidity

Keynes similarly defines the characteristics of a liquid asset as realisable at short notice without loss5, or Black, more general and vague as sold in a short time, at a price not too much below the seller would get if he took plenty of time to sell the asset.6 From any of these definitions arises that liquidity has two separate dimensions, a time dimension (realisable at short/fast) and a price dimension (without loss). 2.4 The dimensions of liquidity

In order to understand the influence of liquidity on the pricing of assets and how liquidity affects the decision of investors it is necessary to understand the risk that emerges from illiquid markets. Hence it is useful to look at the two distinctive components of liquidity more closely.7 2.4.1 The time dimension of liquidity The time dimension of liquidity indicates how long it takes until an investor is able to realise an intended investment. It describes the period between the point in time when the investor emits his unlimited market order and the point in time when this order is realised. The time dimension of liquidity is especially important if an investor wants to realise his transaction quickly. The reason why he wants to do so might be a funding shortage and he is forced to sell his assets immediately against cash. Risk that emerges through the time dimension of liquidity can be understood as waiting cost or opportunity cost an investor suffers because there is no demand for his asset - which is a lack of liquidity.8 2.4.2 The price dimension of liquidity The price dimension of liquidity in contrast characterises the change in price that a market order causes as soon as it is realised. It indicates the level of discount an investor has to accept when he is forced to sell quickly. This discount indicates the risk of the price dimension of liquidity and must be understood as additional transaction cost for the selling investor.

5 6

See evidence in Keynes (1930), page 67 See evidence in Black (1971), page 29 7 Goit/Bauwens (2001), Econometric Modelling of Stock Market Intaday, page 7 8 If in the following the term liquid/illiquid is used it actually does not mean that an asset is perfectly liquid or cannot be traded at all. The term liquid/illiquid must be seen relative.

2.5

Depth, breadth and resiliency of markets

In literature the terms depth, breadth and resiliency are frequently used as liquidity dimensions of a market instead of the terms time and price dimension.9 So a market has depth if there are buying and selling orders that have not yet been realised which are close to the reservation price. Additionally a market has breadth if there are many of those above mentioned orders. Finally the resiliency of a market is high, if the underling prices for an asset are restored fast after a disturbance. This characterisation of liquidity is compatible with the above used dimensions. Yet it is notable that depth, breadth and resiliency merely emphasize the price dimension. However this should not be a problem if assets are traded in highly organized markets where orders can be obtained almost instantaneously. Another explanation is that it is very seldom that there is no demand for an asset on a market at any price. Maybe the discount for immediate realisation will be high but this is rather reflected in the price dimension than in the time dimension. Therefore depth, breadth and resiliency can be seen as a specification of the already introduced price dimension and give already a first hint for measuring liquidity. 2.6 Measuring market liquidity

Measuring liquidity is not easy. In older studies it was even said that it is impossible to measure it.10 More recently undertaken studies do not go so far. Anyhow Baker (1996) remarks that all liquidity measures suffer from one or more limitations.11 There are numerous studies about the quality of liquidity measures.12 This paper does not want to discuss advantages and disadvantages of individual measuring methods and proxies for liquidity. It rather wants to show from where to start. As shown above liquidity can be decomposed into different dimensions. The different methods to measure liquidity use at least one dimension and try to quantify it. As also pointed out above, the time dimension of assets alone is not significant enough and can even be ignored under certain conditions. The

See Garbade (1982), page 420ff Mankower/Marschak (1938), page 284 11 Baker (1996), page 1 12 Therefore see Habrouck (1990) and Baker (1996)
10

measuring methods therefore mainly aim at the price dimension of assets or at least at one of the three components: market depth, breadth and resiliency. In literature the ask-bid spread is often used as a proxy for liquidity.13 It measures the difference between the price quoted by a market maker for an immediate sale (bid) and an immediate purchase (ask). Whereas an asset is the more liquid the lower the spread is. The advantage of this method is that it already measures liquidity monetarily. The spread - as already shown under 2.4 - must be seen as additional transaction cost or illiquidity cost.

The value of liquidity

This chapter deals with the question how illiquidity respectively liquidity risk affects the expected returns and the pricing of assets. As already discussed illiquidity must be seen as potential costs an investor has to bear when selling an illiquid asset. These costs reduce the investors return. So an investor will intuitively prefer a liquid asset to an illiquid asset, assuming that all the other characteristics are identical. An investor will only accept an additional illiquidity risk for holding an illiquid asset if he is compensated with a higher return or an illiquidity discount on the price of the illiquid asset. Thereby the higher return respectively the discount on the price of the asset must at least be equal to the potential illiquidity cost. This can be shown in a reduced form for a single investor14:

P =

d i Ci r
f

(3.01)

E r =r
i

()
i

Ci P
i

(3.02)

The price of an illiquid asset P here is simply computed by a constant dividend

d i minus potential illiquidity cost Ci, discounted by a risk free rate rf. Where

denotes the possibility 0 1 that the asset must be sold.

Although this model is simplified and only valid under restrictions it properly shows that the influence of the illiquidity risk loses influence with a rising holding period (an increase of ).

13 14

Amihud/Mendelson (1988) In this theoretical model the simplified assumption is that all other factors are constant over the time and liquidity is the only risk of the asset.

In the following this simplified model is left in favour of a more general model that reflects the influence of illiquidity on assets.

From CAPM to a Liquidity Asset Pricing Model

For the valuation of investments in economic literature it is mainly proposed to discount future cash flows with a risk-adjusted discount rate. For this application the risk-adjusted discount rate is mainly computed with the Capital Asset Pricing Model.15 It was the merit of the later Nobel Prize Winner in Economics, Harry M. Markowitz (1952), to point out the importance of risk for investment decision. According to his theory the aim of an investor is not only to maximize his expected returns but also to calculate expected returns against the risk he has to take within a portfolio. In the Capital Asset Pricing Model of Sharp (1964), Lintner (1965) and Mossin (1966), Markowitzs idea was used to derive the equilibrium prices of assets. The appropriate expected return of an asset is computed as followed with the CAPM:
f Et rti+1 = r + Et rtM1 r f +
cov t r i , r M t +1 t +1 = var M t r t +1

( )

(4.01)

(4.02)

The main point of criticism on the CAPM is the assumption of frictionless markets. As we have seen above an important form of market friction can be the lack of liquidity in markets. This risk is not integrated in the Standard CAPM. Therefore the further intention is to integrate the liquidity risk into the CAPM. Thereby the derivation of a Liquidity Adjusted CAPM follows the model by Acharya and Pedersen (2005). As already seen in the simplified model in equation 3.02, the expected return of an illiquid asset depends on two main components: (i) the return that is realised

15

Copeland, Koller & Murrin (1989), Valuation: Measuring and Managing the Value of Companies, McKinsey & Company

under the assumption of perfect markets and (ii) the illiquidity risk in terms of additional transaction cost, which lowers the return. It seems intuitive that not only the observed asset i is exposed to an illiquidity risk but also the market portfolio the CAPM uses for risk adjusting. The expected return of an illiquid asset is therefore computed with a liquidity adjusted CAPM which depends on the following components: The return of an asset i that can be realised under the assumption of a frictionless market,

rti =

Dti + Pti , Pti1

(4.03)

minus its relative illiquidity cost,

cti =

Cti Pti1

(4.04)

on the market return gross of illiquidity cost,

rtM =

i S i (Dti + Pti ) , i S i Pti1

(4.05)

and on the relative illiquidity cost of the market portfolio

ctM =

i S i Cti . i S i Pti1

(4.06)

Where at time t, asset i pays a dividend Dti with the ex- dividend share price Pti and illiquidity cost of Cti . There are I assets indexed i= 1,2,3 with a total of Si shares of assets i. For modelling a liquidity-adjusted CAPM of return net of illiquidity cost there are only a few modifications from the Standard CAPM necessary. From the returns of the Standard CAPM the respective illiquidity cost are subtracted in order to get a liquidity-adjusted CAPM in net returns: net f i Et rti ct r + Et rtM ctM r f +1 +1 = +1 +1

(4.07)

cov t r i c i , r M c M t +1 t +1 t +1 t +1 net = var M t r c M t +1 t +1

(4.08)

In the net LAPM the risk premium, as well as the risk beta are modified through the influence of illiquidity. On assumption of frictionless markets and illiquidity cost equal to zero, we get the same result as in equation 4.01, which means that the Standard CAPM holds. In contrary to the simplified model in equation 3.02 the risk adjusted expected return does not only depend on the characteristics of the observed asset but also on the relative characteristics of the asset in comparison to the market portfolio.

The LAPM

Although the model derivated in equation 4.07 is intuitive and there are only a few modifications necessary to incorporate the influence of liquidity - it is more practical to work with a LAPM in gross returns (see 5.5). This will be derivated and consists of the following components: 5.1 Risk-free rate of interest rf (5.10)

Just like in the Standard CAPM the risk-free rate of interest is a positive part of equation of the LAPM equation. That is because: if an asset is not exposed to risk and if it would be possible to trade it on a frictionless market, the expected return of an asset is equal to the risk-free rate of interest. 5.2 Illiquidity cost

Et cti +1

( )

(5.20)

As already derived in equation 3.02 an investor will demand a premium on the expected return in amount of the illiquidity cost, because they reduce his returns when selling the asset. Therefore the expected illiquidity costs of the asset in equation 3.17 are transferred to the right hand side of the equation where they now affect the expected gross return positively. Thus the expected return rises with higher illiquidity cost.

5.3

Risk premium

t = Et rtM1 ctM1 r f + +

(5.30)

The risk premium of the market results from the return of the market net of illiquidity cost minus the risk-free rate of interest. It is needed for the risk adjustment of the expected returns and stands for the additional return an investor expects if he holds an asset with the same risk as the market portfolio in comparison to a save bond. The risk premium and therefore the expected return falls c.p. with rising illiquidity cost and increases with a rising market return. 5.4 The risk betas

Like in the Standard CAPM the risk premium is multiplied with the different risk factors in order to adjust the expected return to risk. Unlike the simplified model in equation 3.02 - the models of Acharya and Pedersen (2005) allow variation in return as well as variation in illiquidity cost over the time.16 It is obvious that return underlies market fluctuations but also illiquidity cost vary over the time.17 That is partly due to changes in funding liquidity and macroeconomic liquidity. This aspect is integrated in this model because not only present illiquidity cost must be incorporated in the expected returns but also the insecurity about the future development. This insecurity can be understood as an additional illiquidity risk and results from the relative dependency between ri, ci to the market determinants rM,cM. The following covariances:

covt rti+1, rtM1 , +

cov t cti +1 , ctM1 , +

covt rti+1, rtM1 +

and

cov t cti +1 , rtM1 , +

resulting from the relative connectivity between the different components can be seen as different risk factors an investor wants to be compensated for with a risk premium. They stand for the systematic risk of an asset. The covariances are divided through the overall risk of the market which results from the variance of market return net of illiquidity cost. Thus result four risk betas equivalent to the net beta in equation 4.08.

16 17

That holds for the net LAPM as well. See evidence in Brunnermeier/Pedersen (2005)

5.4.1 Standard market beta

t =

covt r i , r M t +1 t +1 vart rtM1 ctM1 + +

(5.41)

The modified market beta can be understood similar to the standard beta in equation 4.02. This beta describes the relation of the returns of an asset with that of the market portfolio. It measures the part of the asset's statistical variance that cannot be alleviated by a diversification provided by a portfolio of many risky assets, because of the correlation with the return of the other assets in the portfolio. That is why investors want to be compensated and the beta has a positive sign in the equation. 5.4.2 The three liquidity risks 5.4.2.1 Commonality in liquidity beta

tL1=

cov t c i

,c M t +1 t +1 vart rtM1 ctM1 + +

(5.421)

This beta indicates the risk that an asset gets illiquid when the whole market gets illiquid. It can be expected that this expression is positive for most securities.18 This is intuitive because in an illiquid market it is likely that the illiquidity of an asset rises, too. A high covariance indicates a high sensitivity towards illiquidity of an asset, simultaneously to an illiquid market. The expected return must rise with a rising covariance because investors want to be compensated for an additional illiquidity risk in illiquid markets. Therefore this beta has a positive sign in the equation. 5.4.2.2 Return exposure to market liquidity beta

tL 2 =

covt r i , c M t +1 t +1 vart rtM1 ctM1 + +

(5.422)

This beta stems from the risk that an investor holds an asset which generates a low return in times of illiquid markets. The beta has a negative sign in the equation because investors are willing to accept a lower return on an asset in times of liquid markets.19 This can be understood as an insurance against

18 19

See evidence in Hasbrouck/Seppi (2001) Which implies a positive covariance

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illiquidity. But in times of market illiquidity they demand a premium on their return. Usually this covariance is negative because market-wide illiquidity reduces the values of assets.20 The more negative the exposure of the asset to market illiquidity - the higher the negative covariance and the expected return. This effect is ensured by the negative sign of this beta in the equation. 5.4.2.3 Liquidity exposure to market return beta

tL3 =

cov t c i

,r M t +1 t +1 vart rtM1 ctM1 + +

(5.423)

This beta indicates the risk that an asset becomes illiquid when the market is down. Investors are willing to accept a discount on the expected returns if an asset remains liquid in a down market. This is if the covariance between the illiquidity cost of an asset and the return of the market is positive. Therefore this beta has a negative sign in the equation. Empirical investigations however show that assets have higher illiquidity in bear markets.21 This is especially annoying for an investor because when his returns are low he additionally has to accept high illiquidity cost. Therefore it is intuitive that the investor wants to be compensated for holding an asset that becomes illiquid in times of a down market. The expected return rises due to the negative sign in the equation with a negative covariance. 5.5 Liquidity Adjusted CAPM in gross return
f Et r i = r + Et c i + t t + L1 L 2 L3 t +1 t +1

( )

( ) (

(5.5)

As shown illiquidity rises expected returns. Investors do not only demand compensation for the present liquidity level ci, but also for potential liquidity risks caused by the three liquidity betas that were introduced. Moreover not only the liquidity of an asset is important but also its relative liquidity in proportion to that of the market. Vice versa illiquidity lowers the current price of an asset because the cash flows of an illiquid asset are discounted with a higher risk- adjusted rate. On the other hand investors are willing to pay a premium for an asset that is liquid, respectively accept a lower return.
20 21

See evidence in Amihud (2002) See evidence in Acharya/Pedersen (2005)

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Empirical back testing of the model

The presented model of a liquidity- adjusted CAPM seems to be conclusive. In this chapter the empirical tests of Acharya and Pedersen (2005) are presented in order to find out how important liquidity is for the pricing puzzle. Additionally they tested how properly the LAPM reflected the return expectations. For their tests Acharya and Pedersen (2005) derivated an unconditional version of the illiquidity betas using the innovations in return and illiquidity cost. For measuring illiquidity they followed Amihud (2002) using a return to transaction volume ratio in USD. Therefore they formed a set of 25 test portfolios using monthly data of common shares listed on NYSE and AMEX between 1964- 1999 and sorted them on the basis of illiquidity. In the following extract the most liquid and most illiquid portfolio is shown:

Table: Properties of illiquidity portfolios Source: Acharya , Pedersen (2005), page 391 As one can see the portfolio which is illiquid in absolute terms (cp), also tends to have higher liquidity betas. The algebraic signs of the different betas confirm the intuitive derivation in the previous chapter. Notable but not astonishing is that the illiquid portfolio has a small turnover (trn) and a small market capitalisation (Size). Intuitively it could be argued that the information of a big- sized company is less asymmetric among the investors because there is more information to adapt expectations. Therefore usually the trading volume of bigger- sized companies is higher. This could be an advice that the often discussed size factor could also bee seen as a liquidity effect. 22 Furthermore Acharya and Pedersen (2005) tested how strongly the different liquidity risks affected the expected returns and if empiricism could be represented through the LAPM. Thus Acharya and Pedersen (2005) ran a regression for the LAPM and the Standard CAPM.
22

The size factor is discussed in Fama/French (1995)

12

They found that from the LAPM resulted a higher R2 for cross-sectional returns than from the Standard CAPM.23 The integration of liquidity helps to decompose the expected returns into different components. Thus liquidity can be seen as an important factor which influences the pricing puzzle. The regression also provided information about the total significance of liquidity. For the observed period from 1964- 1999 Acharya and Pedersen (2005) calculated a risk premium of 3.5% p.a. for the level of liquidity between the portfolio with high liquidity and low liquidity. The three liquidity betas contributed a premium of 1.1% p.a. between the liquid and the illiquid portfolio. Decomposing the three liquidity betas they got: (i) A return premium due to the commonality in liquidity of 0.08% p.a..This premium stems form the risk the investor wants to be compensated for if an asset gets illiquid when the whole market gets illiquid. (ii) They got a return premium of 0.16% p.a. due to the return sensitivity to market liquidity. This stems from the risk that an investor holds an asset with low return in times of illiquid markets. (iii) At last they estimated a return premium due to the risk that an asset becomes illiquid, when the market is down. This seems to be the most important source of illiquidity risk. For the analyzed period Acharya and Pedersen (2005) calculated a premium due to the cov t c i , r M of 0.82%. t +1 t +1 In total they estimated a return premium of 4.6% p.a. in the portfolios due to the combined effect of the differences in illiquidity risk and the level of illiquidity. Obviously the significance of liquidity is high and valuable. Liquidity must therefore be seen as an important fundamental factor, defining the returns and the value of an asset.24

Conclusion

Illiquidity in assets is a risk that must be seen as additional transaction cost. For holding an illiquid asset investors want to be compensated with a risk premium

23

To the same results came Hagemeister/Kemp (2007) when they tested the LAPM based on the return expectations of analysts. 24 Hou/Karolyi/Kho (2006), What Factors Drive Global Stock Returns

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on their return. The Standard CAPM assumes frictionless markets and does not reflect the risk due to illiquidity. Therefore Acharya und Pedersen (2005) derivated a liquidity adjusted CAPM for returns net of illiquidity cost. This is easily derivated from the CAPM. For the valuation of assets it is more practical to use the LAPM in gross returns. In this model Acharya and Pedersen diecomposed the influence of liquidity on returns in the following components: The level of liquidity which could be understand as illiquidity cost an investor has to accept when he wants to sell his asset immediately. The commonality in liquidity beta which indicates the risk that an asset gets illiquid when the whole market gets illiquid. The return exposure to market liquidity beta which stems from the risk that an investor holds an asset with low return in times of illiquid markets. The liquidity exposure to market return beta which indicates the risk that an asset becomes illiquid when the market is down. In the empirical back testing this component turned out to be the most influencing liquidity risk. Also due to back testing there was empirical evidence that the LAPM explains data better than the Standard CAPM in form of R2. From this follows that liquidity is an important and valuable fundamental factor that influences the price and return of an asset.

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