Iman Honarvar
Maastricht University, the Netherlands
December 23rd, 2015
Abstract: I provide a theoretical justification for the positive relationship,
previously empirically found between VIX and the equity shortterm price reversal. I
show an idiosyncratic liquidity shock to an asset creates a shortterm reversal
effect in this asset and any asset correlated with it, and thus, it spreads to the
whole market. The strength of the shortterm reversal effect in the market
depends on assets covariances. Given that VIX is a proxy for stocks average
covariance, the positive relationship between VIX and the equity shortterm
reversal must exist. My empirical tests confirm my theoretical conjecture and
show that the returns of the equity shortterm reversal strategies are robustly
related to the different measures of stocks average covariance, such as VIX
and realized volatility of the S&P500 Index, and also average conditional
correlation and average conditional variance.
Email: i.honarvargheysary@maastrichtuniversity.nl.
1. Introduction
Market makers set their bid and ask prices such that they are always ready to trade. At the time
of investors urgency to sell a specific asset, which usually coincide will the price fall, the market
makers are ready to buy, hoping that they can sell back to the market in a few hours (days) when
the price recovers. Thus the compensation for market makers liquidity provision is closely
related to the shortterm price reversal effect. Nagel (2012) empirically shows that VIX can
positively predict the price reversal effect. He argues when VIX is high, market makers are
financially constrained (Brunnermeier and Pedersen (2008)), and therefore they require higher
return for the liquidity provision.
In this paper, I extend the unified framework of Vayanos and Wang (2011) to provide another
theoretical justification for the positive connection between VIX and the shortterm price
reversal effect. I will show that even in a perfect market, where there is no information
asymmetry and the market makers are not financially constrained, an increase in the average
level of assets covariances, i.e. an increase in VIX, creates a larger price reversal effect in the
whole market.
Previous theoretical and empirical studies show that a trade with information asymmetry
coincides with a price movement that does not revert; however, a price change in a noninformed
trade1 usually reverts.2 Therefore to study the price reversal, I reply on a perfect market model
1
A noninformed trader can be a perfect rational riskaverse hedger, who allocates his portfolio
based on the publicly available information rather than personal insider information. Therefore
noninformed trading differs from noise trading, whose trade volume is a pure random walk.
The extra endowment that triggers the trade, the liquidity shock, can be idiosyncratic or
systematic. I will show (e.g.) an idiosyncratic liquidity shock to asset i affects the price of this
asset and any asset correlated with it, and therefore, it can create a shortterm price reversal
effect in the whole market. Ceteris paribus, the intensity of the price reversal effect is much
stronger when the investors are more riskaverse, the liquidity shock is bigger, or when the assets
covariances are higher. Given that VIX is a proxy for stocks pairwise conditional covariances,
when VIX is higher, the shortterm price reversal effect is stronger.
2
See Kyle (1985), Glosten and Milgrom (1985), Campbell, Grossman and Wang (1993),
Llorente, Michaely, Saar and Wang (2002), Avramov, Chordia and Goyal (2006).
Indeed my further empirical analysis confirm this claim. To capture market makers profit from
the shortterm price reversal effects for each day from 1996:1 to 2014:8, I construct portfolios
which buy (sell) the assets that underperformed (outperformed) the market over the last day(s). I
will show that the return of these portfolios are substantially positively related to VIX (a proxy
for the average covariance under the Qmeasure), the realized volatility of the S&P500 (a proxy
for the average covariance under the Pmeasure), the average conditional correlation (Driessen,
Maenhout, Vilkov (2009)) and the average conditional variance (Bakshi, Kapadia and Madan
(2003)) of the stocks in S&P100 index. The robustness tests show that the proxies of market
financial constraints, such as the LIBOROIS spread, the TedSpread, the 1month USD LIBOR
and the Federal Fund Rate, cannot obsolete the power of the average covariance in capturing the
shortterm price reversal effect.
My research is also related to several other previous studies; Bansal, Connolly and Stivers (2014)
and Chung and Chuwonganant (2014) empirically find that the level of VIX is closely related
with stocks return, turnover and illiquidity. Cespa and Foucault (2014) study illiquidity spillover
from price informativeness perspective. Also So and Wang (2014) find that uncertainty
escalation increases the market makers excepted compensation for providing liquidity. Cheng,
Hameed, Subrahmanyam and Titman (2014) find that the magnitude of return reversals depends
on the number of informed investors and riskaverse market makers, and Andrade, Chang and
Seasholes (2008) study illiquidity spillover among correlated stocks.
The rest of the paper is structured as follows. Section 2 presents my theoretical model and its
implication about the shortterm price reversal effect in the market. In Section 3, I empirically
test the predictions of my theory, and finally in Section 4, I draw the conclusion.
2. The Model
The economy contains one riskless bond and N risky assets that can be traded in three periods
(t = 0,1,2). The riskfree interest rate is equal to zero, and the riskless bond is in perfectly elastic
supply. The liquidation values of the risky assets at the final period (t = 2) is jointly normally
distributed such that
S2 ~N(S, )
(1)
(2)
where Et (. ) is the expectation function given all the information available at and before time t.
This is equivalent to assuming that the economic factors, associated with the asset fairprices, are
constant over the horizon of the study from t = 0 to t = 2. Since we study the shortterm price
reversal effect that materializes within a few days, this is not a strong assumption.
Investors willingness to trade and preferences, endogenously, dictate the risky assets prices at
Period 0 (i.e. S0 , the N 1 vector of the risky assets price at t = 0), and at Period 1 (i.e. S1, the
N 1 vector of the risky assets price at t = 1). In order to quantify the price reversal effect, we
must find the asset prices at these two periods.
Investors will consume all their wealth at Period 2, and they have identical exponential utility
functions,
5
U(C) = exp(C),
(3)
where and C are, respectively, the coefficient of riskaversion and the consumption level.
At Period 0, the investors are identical. They have the same initial wealth, riskaversion
coefficients and utility functions. Therefore at Period 0, all investors hold the market portfolio
besides the riskless bond i.e.
0 = .
(4)
Here 0 is the N 1 vector of the investors holdings at Period 0, and is the N 1 vector of
the market portfolio.
At Period 1, a population 0 < < 1 of the investors are informed that they will get the extra
endowment of zM(S2 S) at the final period (t = 2). Here z is a normally distributed random
variable such that z~N(0 2z ) and E(zS2 ) = 0. I refer to z as the liquidity shock. Moreover M
is the N 1 vector of assets sensitivity to (loading on) the liquidity shock. Although these
investors are informed about the size of the liquidity shock (z) at Period 1, they will receive the
endowment at Period 2.
Lets assume that the liquidity shock only hits the ith asset.3 In other words all the elements in M
are zero except the ith , which is equal to 1. At Period 1, when the population of the investors
3
Without loss of generality, in my model I assume that the liquidity shock is assetspecific. In
other words, the population of the investors get the extra endowment for only one of the assets.
Therefore I assume that only one element in the vector M is equal to 1, and the rest of the
elements are zero. Obviously, to study the effect of a systematic liquidity shock, which affect
6
get the news about the extra endowment, they know that if they do nothing their portfolio will
deviate from its optimality for the next time interval, from t = 1 to t = 2. This news persuades
them to rebalance their portfolio such that it remains optimal. For example if they are informed
that z is positive, they will have more than enough (optimal) units of the ith asset at Period 2.
Therefore at Period 1, they must reduce their exposure to the ith asset by selling a portion of their
holdings on this asset. Since the investors, who get the extra endowment, initiate the trade they
are called the liquidity demanders (indexed with d). The rest of the investors (1 ), who
accommodate these demands, are called the liquidity suppliers (indexed with s).
The liquidity suppliers and the liquidity demanders are equally riskaverse. Since the liquidity
suppliers portfolio is already optimal, they do not have any incentive to buy the ith asset unless
the price of asset i is lower that its riskadjusted expected payoff. Hence the liquidity suppliers
provide liquidity to the market by charging a liquidity premium, a price discount on asset i.
Remarkably, it is the liquidity suppliers riskaversion that creates temporary jumps in prices.
These jumps are the liquidity suppliers compensation for providing liquidity and immediacy to
the market. The riskaverse liquidity suppliers of my model resemble the riskaverse market
makers in the models of Grossman and Miller (1988), Brunnermeier and Pedersen (2008), and
Andrade, Chang and Seasholes (2008).
The implications of the outlined model are presented in the following four propositions.
Appendix A provides the proofs of all propositions.
several assets with different magnitudes, one could assume that M is the vector of the factor
loadings on the liquidity risk.
Proposition 1: As mentioned before, at Period 0 the investors are identical and they hold the
same portfolios 0 = . However at Period 1, they will be randomly segregated to the liquidity
demanders and the liquidity suppliers. The liquidity demanders are informed that they will
receive the extra endowment of zM(S2 S) at the final period (t = 2). After knowing the size
of the liquidity shock (z), the liquidity demanders will reallocate their portfolios to hold 1d units
of the risky assets. One can show that the N 1 vectors of the liquidity demanders optimal
holding (1d ) and the liquidity suppliers optimal holding (1s ) are respectively:
1d =
1 1
(S S1 ) zM,
(5)
1 1
(S S1 ).
(6)
1s =
Proposition 2: At Period 1 the liquidity demanders initiate the trade. To persuade the liquidity
suppliers to engage in this trade, the prices (S1) must adjust. One can show that the Period 1
equilibrium asset prices are:
S1 = S zM.
(7)
Therefore an assetspecific liquidity shock to the ith asset will be transmitted to all other assets
that have a nonzero covariance with asset i.
Proposition 3: At Period 1, when the size of the liquidity shock z is known, the asset prices
deviate from their fundamental values, but later in Period 2, they converge back. This
phenomenon is called the shortterm price reversal, and it is measured as the negative of the
autocovariations in the price processes, i.e.
= diag(Cov(S2 S1 , S1 S0 )).
(8)
Here diag(. ) returns the diagonal elements vector and Cov(S2 S1 , S1 S0 ) is the N N matrix
of the autocovariation in the price processes. One can show that
= 2 2 2z diag(MM ).
(9)
When an assetspecific liquidity shock affects the ith risky asset, it will created shortterm price
reversal effect in asset i and the assets correlated with it. The magnitudes of the price reversal
effects for any asset (j) and the market portfolio index (m) will be:
j = 2 2 2z 2ij .
N
m
(10)
2 2 2z wk wj ik ij
(11)
k=1 j=1
Here wi stands for the weight of asset i in the market portfolio index, and ij is the covariance
between assets i and j.
Proposition 4:4 The price of the assets before observing the liquidity shock z will be,
S0 = S
( 1 )
0
1 +
(12)
Such that
4
Proposition 4 is not directly used in this paper, but it is very useful in understanding the
connection between the liquidity risk premium and assets pairwise covariances.
0 = (1 + 2 2z (2 2)M M)
(13)
1 = 2 2z M
(14)
= 
1 + 2 2z 2 M M
2 M1
 exp (
)
0
20
(15)
For example if asset i is prone to the liquidity shocks z~N(0 2z ), then exante price of any
asset j in this market will be
S0j = Sj k kj
k=0
( 1 )
0
1 +
(16)
ji
Thus even though the liquidity shock hits asset i, the investors will require
1
)
0
1+
ji as the
liquidity risk premium for investing on asset j, because a liquidity shock spreads to any
correlated asset.
3. Empirical Results
The theory predicts when assets pairwise covariances are higher, the price reversal effects are
stronger. Therefore since VIX is a proxy for stocks pairwise conditional covariances, it must be
closely related to the shortterm reversal effect in the stock market. In this section, I test the
validity of this theoretical finding. I construct different shortterm price reversal strategy
portfolios and show that they are more profitable when the average level of the covariances
increases. For each day these portfolios buy the stocks with negative marketadjusted returns
over the last day, and shortsell the stocks with positive marketadjusted returns, hoping that
these returns will be reverted in following day. By using the marketadjusted returns, I make sure
10
that in everyday, the price reversal strategy portfolio has both long and short positions. Having
both long and short positions reduces the portfolio exposure to other risk factors such as the
FamaFrench risk factors.
In a relevant study, Nagel (2012) proposes and compares the three weighting strategies shown in
Equation 17 to 19. Model 1 and 2 have been also used by Lehman (1990) and Lo and MacKinlay
(1988), respectively.
Method 1:
Method 2:
Method 3:
wi,t =
R m,t1 R i,t1
1
( 2 N
i=0 R m,t1 R i,t1 )
wi,t =
wi,t =
R m,t1 R i,t1
N
(17)
(18)
R m,t1 R i,t1
2
1
( 2 N
i=0(R m,t1 R i,t1 ) )
(19)
I also follow Nagel (2012) and use these strategies for the empirical part of the paper. Clearly the
weight of each stock on each day depends negatively on its marketadjusted return on the
previous day. If on day t 1 a stock outperforms (underperforms) the market, the weight of this
stock on day t will be negative (positive). Therefore if its good (bad) performance on day t 1 is
reverted with a bad (good) return on day t, this stock will contribute positively to the day t
portfolio return. To construct the price reversal strategy portfolios, I obtain the daily closing
transaction prices of the stocks, traded in NYSE, AMEX and NASDAQ from the CRSP
database.
Hansch, Naik, and Viswanathan (1998) show that especially for illiquid stocks, the price
reversion might take more than one day. Also Hendershott, Menkveld (2014) find that the
11
average price pressure caused by asynchronously arriving investors is about 0.49% with a halflife of 0.54 to 2.11 days. Therefore following Nagel (2012), I also construct five independent
portfolios such that the weight of each asset depends on j = 1, , 5 days (past week) delayed
stock returns, and then I take the simple average of the constructed portfolio returns.
I also compute the daily realized volatility of the S&P 500 Index, as a proxy for the average
covariance of the stocks under the Pmeasure. To this end, I calculate each days realized
volatility as the standard deviation of the intraday (5minute) observations on the S&P 500 Index
return, taken from the Tick Data. Moreover using the mythologies of Bakshi, Kapadia and
Madan (2003) and also Driessen, Maenhout, Vilkov (2009), I compute the average conditional
correlation and the average conditional variance of the S&P 100 stocks. For this purpose, I
obtain the daily prices of the options traded on the S&P 100 Index and its constituents from
OptionMetrics database.
Summary Statistics
Table 1 provides summary statistics on the market and the price reversal strategy portfolios. The
frequency of the time series is daily, and they range from 1996:1 to 2014:8.
The weighting strategies shown Equation 17 to 19, by construction, tend to buy (sell) low (high)
beta stocks in the days that the market return is positive and vice versa. To ensure that the
12
variations of the constructed portfolios are not driven by the market fluctuations, following
Nagel (2012), I neutralize the returns with respect to the market using Equation 20.
(20)
Therefore for the regression analysis, I report the results based on both the return time series of
the portfolios constructed using Equation 17 to 19 (i.e. Price Reversalt ), and also the return of
these portfolios orthogonalized to the market return using Equation 20 (i.e. t ).
Regression Results
To test the theoretical prediction of the model, I regress the daily return of the constructed shortterm reversal portfolios (in basis points) on VIX, the average correlation and the average
variance of the S&P100 stocks. I also include a dummy vector that is equal to one before the
decimalization (i.e. April 9th 2001), and zero after that.
The results, reported in Table 3 and 4, confirm my theoretical conjecture. In both tables, Panel
(A) and (B) respectively refer to the shortterm reversal strategies constructed based on last day
and last week of stock returns. The higher values for VIX, the average correlation or the average
variance of the stocks in the market are generally associated with more positive returns in all of
the shortterm price reversal portfolios. Also the estimated coefficients of the dummy variable
are always significantly positive, meaning that before the decimalization the shortterm reversal
strategies were more profitable.
If the financially constrained balancesheets of market makers are the main derivers of the shortterm price reversal effect in the market, the creditrisk and financing proxies of the market must
be better variables to explain this effect. Therefore I repeat the previous regressions, after adding
the LIBOROIS spread, the TedSpread, the 1month USD LIBOR and the Federal Fund Rate to
the regressors. The results, shown in Table 5 and 6, suggest that none of these proxies can
obsolete the substantial relationship between VIX and the shortterm reversal. 5
Remarkably, based on the results shown in Table 5 and 6, the estimated coefficients for the 1month USD LIBOR is not always significantly positive and the sign of the estimated coefficients
for the TedSpread are mostly negative. These findings suggest that the role of the covariance in
explaining the shortterm price reversal effect cannot be replaced by the financial constraints
proxies.
To test the robustness of the results found in Table 5 and 6, I run these regressions again after
adding the market excess return, SMB, HML, momentum and the S&P 500 dividend yield to the
The LIBOROIS spread, the 1month USD LIBOR and the Federal Fund Rate are extremely
correlated. To avoid multicollinearity, I only use one of these time series beside the TedSpread
as the regressors. In Table 5 and 6, I only report the results based on one of these combinations,
i.e. the 1month USD LIBOR and the TedSpread. The other combinations provide qualitatively
similar results, excluded for the sake of brevity. These results are available upon request.
14
regressions. In every case, VIX is substantially positively related to the return of all shortterm
price reversal portfolios.
VIX Index is the measure of the market volatility expectation under the riskneutral measure, and
therefore, it is the summation of the realized volatility and the volatility risk premium. To ensure
that the variations in the shortterm price reversal are not driven by the volatility risk premium, I
repeat the regressions with the daily realized volatility. For this purpose, I compute the
conditional volatility of each day using 5minutes observations on the S&P 500 Index returns.
The results, provided in Table 8 to 10, are qualitatively the same as my findings for VIX; the
realized volatility for the S&P 500 Index, which is a weighted sum of stockspairwise
covariances, is significantly positively correlated with the shortterm price reversal in the stock
prices.
4. Conclusion
The shortterm price reversal effect is known to be a proxy for the market makers liquidity
provision compensation. Previous studies empirically show a positive relationship between VIX
Index and the shortterm price reversal effect. These studies argue that when VIX Index is high,
the shortterm price reversal effect is stronger, because in such periods the market is in turmoil
15
and therefore financially constrained market makers expect more compensation for providing
liquidity.
In this paper, I provide another theoretical justification for the positive relationship between the
shortterm price reversal effect and VIX Index. More specifically I show that a liquidity shock
can create shortterm price reversal effect in the whole market, and the intensity of this reversal
effect is higher when the covariance values among assetpairs are higher. Since VIX Index is a
proxy for stocks pairwise conditional covariances, the positive relation between VIX and the
shortterm price reversal effect must exist.
My further empirical analyses robustly confirm my theoretical findings. More specifically, I find
that return of shortterm reversal strategies are substantially positively related to VIX (a proxy
for the average covariance under the Qmeasure), the realized volatility of the S&P500 (a proxy
for the average covariance under the Pmeasure), the average conditional correlation and the
average conditional variance of the stocks in S&P100 index.
16
Tables
S&P 100
Volatility
5%
1.92%
10%
S&P 100
Average
Correlation
S&P 100
Average
Variance
0.105
0.238
1.37%
0.114
25%
0.52%
Median
Summary Statistics
Percentiles
Method 1
Method 2
Method 3
Method 1
Method 2
Method 3
0.036
0.39%
0.00%
3.18%
0.74%
0.01%
5.81%
0.272
0.039
0.20%
0.00%
1.49%
0.25%
0.00%
2.15%
0.141
0.366
0.049
0.06%
0.00%
0.53%
0.37%
0.00%
3.21%
0.09%
0.188
0.446
0.075
0.33%
0.00%
2.46%
1.13%
0.01%
8.75%
75%
0.65%
0.231
0.544
0.127
0.69%
0.01%
4.40%
2.50%
0.03%
14.87%
90%
1.33%
0.29
0.642
0.201
1.04%
0.01%
6.25%
3.73%
0.05%
21.21%
95%
1.82%
0.347
0.715
0.259
1.36%
0.02%
7.85%
4.57%
0.07%
24.79%
Number of
Observations
4696
Beta
..
..
..
0.12
0.84
0.18
1.18
Annualized Sharpe
Ratio
0.52
..
..
..
9.14
7.01
10.09
12.89
10.43
14.61
Average
0.04%
0.2
0.46
0.1
0.40%
0.01%
2.50%
1.50%
0.02%
9.09%
St. Dev.
1.25%
0.08
0.14
0.08
0.70%
0.01%
3.94%
1.85%
0.03%
9.88%
Skew
0.11
1.71
0.43
2.31
1.54
5.98
1.09
0.7
2.45
0.08
Kurt
7.04
5.35
0.15
8.45
28.34
89.66
14.81
7.16
22.49
2.99
Moments
17
Correlations
HML
Mom
Ted
Spread
Dividend 1MUSDYield
LIBOR
Value Weighted
Market Return
1.00
0.12
0.11
0.10
0.07
0.13
0.26
0.03
0.02
0.01
0.21
0.19
0.26
0.13
0.15
0.15
0.12
1.00
0.58
0.88
0.03
0.03
0.00
0.50
0.28
0.01
0.24
0.32
0.14
0.32
0.42
0.21
0.11
0.58
1.00
0.16
0.04
0.01
0.02
0.08
0.25
0.44
0.08
0.07
0.07
0.12
0.12
0.12
0.10
0.88
0.16
1.00
0.02
0.03
0.01
0.55
0.46
0.21
0.23
0.33
0.11
0.28
0.42
0.16
SMB
0.07
0.03
0.04
0.02
1.00
0.15
0.08
0.02
0.00
0.02
0.01
0.01
0.06
0.04
0.06
0.01
HML
0.13
0.03
0.01
0.03
0.15
1.00
0.28
0.03
0.01
0.01
0.06
0.06
0.06
0.02
0.03
0.02
Mom
0.26
0.00
0.02
0.01
0.08
0.28
1.00
0.01
0.04
0.04
0.02
0.01
0.03
0.04
0.02
0.06
Ted Spread
0.03
0.50
0.08
0.55
0.02
0.03
0.01
1.00
0.12
0.40
0.16
0.23
0.09
0.18
0.27
0.12
Dividend Yield
0.02
0.28
0.25
0.46
0.00
0.01
0.04
0.12
1.00
0.38
0.13
0.18
0.05
0.13
0.21
0.05
1MUSDLIBOR
0.01
0.01
0.44
0.21
0.02
0.01
0.04
0.40
0.38
1.00
0.18
0.18
0.13
0.27
0.28
0.25
Method 1
0.21
0.24
0.08
0.23
0.01
0.06
0.02
0.16
0.13
0.18
1.00
0.92
0.88
0.66
0.68
0.55
Method 2
0.19
0.32
0.07
0.33
0.01
0.06
0.01
0.23
0.18
0.18
0.92
1.00
0.75
0.61
0.73
0.46
Method 3
0.26
0.14
0.07
0.11
0.06
0.06
0.03
0.09
0.05
0.13
0.88
0.75
1.00
0.55
0.53
0.60
Method 1
0.13
0.32
0.12
0.28
0.04
0.02
0.04
0.18
0.13
0.27
0.66
0.61
0.55
1.00
0.92
0.88
Method 2
0.15
0.42
0.12
0.42
0.06
0.03
0.02
0.27
0.21
0.28
0.68
0.73
0.53
0.92
1.00
0.74
Method 3
0.15
0.21
0.12
0.16
0.01
0.02
0.06
0.12
0.05
0.25
0.55
0.46
0.60
0.88
0.74
1.00
Portfolios
Conditioned
on the Past
Week
Returns
Portfolios
Conditioned
on the
Yesterday
Returns
18
Value
S&P 100 S&P 100
Weighted S&P 100
Average Average
Market Volatility
Correlation Variance
Return
Model 1
R2 = 0.2416
R2 = 0.2506
Coefficient
Tstat
Coefficient
Tstat
Intercept
0.1698
2.66
Intercept
1.7156
27.29
Dummy
1.5556
29.53
Dummy
1.5453
29.77
VIX
6.2380
20.70
VIX
6.4807
21.83
R2 = 0.2950
Model 2
R2 = 0.3072
Coefficient
Tstat
Coefficient
Tstat
Intercept
0.0158
15.01
Intercept
0.0370
35.99
Dummy
0.0243
27.91
Dummy
0.0241
28.38
VIX
0.1506
30.28
VIX
0.1531
31.51
R2 = 0.1677
Coefficient
Model 3
R2 = 0.1768
Tstat
Coefficient
Tstat
Intercept
2.7975
7.83
Intercept
6.6969
19.07
Dummy
7.7319
26.21
Dummy
7.6568
26.40
VIX
20.8345
12.35
VIX
22.9735
13.85
R2 = 0. 1100
Model 1
R2 = 0.1234
Coefficient
Tstat
Coefficient
Tstat
Intercept
0.0685
2.64
Intercept
0.5022
19.93
Dummy
0.3509
16.36
Dummy
0.3441
16.53
VIX
1.8718
15.26
VIX
2.0521
17.24
R2 = 0.1400
Model 2
R2 = 0.1457
Coefficient
Tstat
Intercept
0.0052
11.14
Dummy
0.0057
14.75
VIX
0.0466
21.15
Coefficient
Tstat
Intercept
0.0113
24.88
Dummy
0.0056
14.89
VIX
0.0492
22.96
R2 = 0.0495
Model 3
19
R2 = 0.0601
Coefficient
Tstat
Coefficient
Tstat
Intercept
0.9647
6.34
Intercept
1.8137
12.42
Dummy
1.5576
12.39
Dummy
1.5059
12.48
VIX
5.5681
7.74
VIX
7.0338
10.19
R2 = 0.2413
Model 1
R2 = 0.2511
Coefficients
Tstat
Intercept
0.5442
6.24
Dummy
1.7523
Ave Correlation
2.6398
3.3838
Ave Variance
Coefficients
Tstat
Intercept
2.1165
24.66
30.97
Dummy
1.7514
31.43
14.94
Ave Correlation
2.7671
15.90
10.23
Ave Variance
3.5172
10.79
R2 = 0.2879
Model 2
R2 = 0.2999
Coefficients
Tstat
Intercept
0.0148
10.25
Coefficients
Tstat
Intercept
0.0366
25.92
Dummy
0.0248
26.44
Dummy
0.0249
27.10
Ave Correlation
0.0343
11.71
Ave Correlation
0.0365
12.74
Ave Variance
0.1278
23.28
Ave Variance
0.1280
23.87
R2 = 0.1879
Model 3
R2 = 0.1988
Coefficients
Tstat
Coefficients
Tstat
Intercept
0.7701
1.60
Intercept
10.4214
22.02
Dummy
9.2931
29.70
Dummy
9.2719
30.18
Ave Correlation
15.3916
15.75
Ave Correlation
16.2988
16.99
Ave Variance
1.8642
1.02
Ave Variance
3.3359
1.86
R2 = 0.1061
Model 1
R2 = 0.1199
Coefficients
Tstat
Intercept
0.0894
2.51
Coefficients
Tstat
Intercept
0.5388
15.62
16.60
Dummy
0.3731
16.16
Dummy
0.3717
Ave Correlation
0.5287
7.34
Ave Correlation
0.6119
8.75
Ave Variance
1.4090
10.44
Ave Variance
1.5237
11.63
R2 = 0.1418
Coefficients
Model 2
R2 = 0.1560
Tstat
20
Tstat
Intercept
0.0034
5.40
Intercept
0.0098
15.83
Dummy
0.0053
12.71
Dummy
0.0052
13.06
Ave Correlation
0.0064
4.97
Ave Correlation
0.0077
6.17
Ave Variance
0.0460
19.00
Ave Variance
0.0474
20.15
R2 = 0.0523
Model 3
Coefficients
R2 = 0.0645
Coefficients
Tstat
Intercept
0.3648
1.76
Coefficients
Tstat
Intercept
2.5225
12.67
Dummy
1.8296
13.57
Dummy
1.8153
14.05
Ave Correlation
3.0867
7.33
Ave Correlation
3.7124
9.20
Ave Variance
2.0662
2.62
Ave Variance
3.0691
4.06
R2 = 0.2461
Model 1
R2 = 0.2565
Coefficients
Tstat
Coefficients
Tstat
Intercept
0.2322
3.05
Intercept
1.8039
24.08
Dummy
1.5617
19.42
Dummy
1.5258
19.27
VIX
7.2331
19.72
VIX
7.6516
21.19
LIBOR1m
1.6881
1.00
LIBOR1m
2.6390
1.58
Ted Spread
0.3684
5.08
Ted Spread
0.4268
5.98
R2 = 0.2967
Model 2
R2 = 0.3102
Coefficients
Tstat
Coefficients
Tstat
Intercept
0.0181
14.36
Intercept
0.0398
32.42
Dummy
0.0213
16.05
Dummy
0.0207
15.97
VIX
0.1601
26.39
VIX
0.1669
28.18
LIBOR1m
0.0894
3.19
LIBOR1m
0.1081
3.96
Ted Spread
0.0028
2.31
Ted Spread
0.0042
3.62
R2 = 0.1723
Coefficients
Model 3
R2 = 0.1825
Tstat
Coefficients
Tstat
Intercept
2.6284
6.17
Intercept
7.0272
16.78
Dummy
8.0169
17.80
Dummy
7.7623
17.54
VIX
25.7926
12.55
VIX
28.8547
14.30
LIBOR1m
2.1678
0.23
LIBOR1m
8.2723
0.89
Ted Spread
1.8990
4.68
Ted Spread
2.1944
5.50
R2 = 0.1102
Model 1
R2 = 0.1245
Coefficients
Tstat
Coefficients
Tstat
Intercept
0.0857
2.76
Intercept
0.5351
17.76
Dummy
0.3313
10.09
Dummy
0.3079
9.67
VIX
1.9664
13.13
VIX
2.2442
15.45
LIBOR1m
0.6557
0.95
LIBOR1m
1.2419
1.85
Ted Spread
0.0300
1.01
Ted Spread
0.0618
2.15
R2 = 0.1426
Model 2
R2 = 0.1568
Coefficients
Tstat
Coefficients
Tstat
Intercept
0.0056
10.11
Intercept
0.0120
22.14
Dummy
0.0046
7.88
Dummy
0.0043
7.45
VIX
0.0446
16.57
VIX
0.0489
18.73
LIBOR1m
0.0217
1.75
LIBOR1m
0.0316
2.62
Ted Spread
0.0010
1.93
Ted Spread
0.0004
0.82
R2 = 0.0497
Model 3
21
R2 = 0.0611
Coefficients
Tstat
Coefficients
Tstat
Intercept
0.9533
5.23
Dummy
1.5892
8.26
Intercept
1.9368
11.09
Dummy
1.4136
VIX
6.0073
7.66
6.84
VIX
8.1173
LIBOR1m
9.64
0.0365
0.01
LIBOR1m
4.2622
Ted Spread
1.10
0.1698
0.98
Ted Spread
0.3764
2.26
Weights Model
Model 1
Model 2
Model 3
Weights Model
Model 1
Model 2
Model 3
22
Weights Model
Model 1
Model 2
Model 3
Weights Model
Model 1
Model 2
Model 3
23
Tstat
18.64
18.49
22.84
5.16
2.61
1.76
6.46
7.16
7.91
4.25
Tstat
18.75
15.48
27.40
6.01
4.08
1.39
5.85
2.40
4.39
4.69
Tstat
18.02
16.61
18.00
4.95
0.50
3.06
8.61
10.63
8.37
4.88
Tstat
10.20
9.34
15.03
3.54
0.13
0.13
5.22
1.21
2.60
2.26
Tstat
9.56
7.40
16.75
3.88
1.12
0.96
4.76
2.10
1.11
1.74
Tstat
9.26
7.13
10.91
3.45
3.30
1.37
7.53
3.92
3.41
2.57
R2 = 0.2258
Model 1
R2 = 0.2327
Coefficient
Tstat
Intercept
0.4161
8.70
Coefficient
Tstat
Intercept
1.1504
24.39
Dummy
1.6058
Realized Volatility
6.2913
30.47
Dummy
1.5978
30.75
16.35
Realized Volatility
6.5330
17.21
R2 = 0.2627
Model 2
R2 = 0.2705
Coefficient
Tstat
Intercept
0.0036
4.35
Coefficient
Tstat
Intercept
0.0253
31.35
Dummy
0.0251
Realized Volatility
0.1724
27.67
Dummy
0.0250
28.10
26.00
Realized Volatility
0.1731
26.65
R2 = 0.1586
Model 3
R2 = 0.1660
Coefficient
Tstat
5.0419
18.95
Dummy
7.7756
26.53
Realized Volatility
19.5463
9.13
Intercept
Coefficient
Tstat
4.5811
17.51
Dummy
7.7162
26.77
Realized Volatility
22.0967
10.50
Intercept
R2 = 0.0932
Model 1
R2 = 0.1037
Coefficient
Tstat
Intercept
0.1231
6.35
Coefficient
Tstat
Intercept
0.3098
16.47
Dummy
0.3649
Realized Volatility
1.7565
17.08
Dummy
0.3595
17.35
11.26
Realized Volatility
1.9641
12.98
R2 = 0.1093
Model 2
R2 = 0.1195
Coefficient
Tstat
Intercept
0.0009
2.57
Coefficient
Tstat
Intercept
0.0071
19.84
Dummy
0.0060
Realized Volatility
0.0486
14.92
Dummy
0.0059
15.11
16.56
Realized Volatility
0.0513
17.93
R2 = 0.0431
Model 3
24
R2 = 0.0512
Coefficient
Tstat
Intercept
1.5604
13.54
Coefficient
Tstat
Intercept
1.1712
10.59
Dummy
1.5832
Realized Volatility
5.1358
12.47
Dummy
1.5422
12.65
5.54
Realized Volatility
6.8954
7.75
R2 = 0.2293
Model 1
R2 = 0.2365
Coefficients
Tstat
Intercept
0.5447
9.38
Coefficients
Tstat
Intercept
1.0293
17.97
Dummy
1.8297
23.31
Dummy
1.8079
23.36
Realized Volatility
6.6097
14.58
Realized Volatility
7.0048
15.67
LIBOR1m
5.4191
3.24
LIBOR1m
4.8099
2.91
Ted Spread
0.1189
1.69
Ted Spread
0.1630
2.35
R2 = 0.2632
Model 2
R2 = 0.2708
Coefficients
Tstat
Intercept
0.0027
2.68
Coefficients
Tstat
Intercept
0.0245
24.96
Dummy
0.0267
19.71
Dummy
0.0264
19.86
Realized Volatility
0.1687
21.56
Realized Volatility
0.1731
22.58
LIBOR1m
0.0479
1.66
LIBOR1m
0.0365
1.29
Ted Spread
0.0009
0.75
Ted Spread
0.0001
0.12
R2 = 0.1639
Model 3
R2 = 0.1717
Coefficients
Tstat
Coefficients
Tstat
Intercept
5.8325
18.07
Dummy
9.1483
20.97
Intercept
3.8483
12.13
Dummy
8.9838
Realized Volatility
22.3510
20.94
8.87
Realized Volatility
25.7353
LIBOR1m
10.39
31.8719
3.43
LIBOR1m
27.7695
Ted Spread
3.04
0.9825
2.51
Ted Spread
1.2191
3.17
R2 = 0.0947
Model 1
R2 = 0.1044
Coefficients
Tstat
Intercept
0.1494
6.34
Coefficients
Tstat
Intercept
0.2886
12.61
Dummy
0.4121
12.93
Dummy
0.3971
12.84
Realized Volatility
1.5451
8.40
Realized Volatility
1.8397
10.30
LIBOR1m
1.5830
2.33
LIBOR1m
1.1923
1.81
Ted Spread
0.0578
2.02
Ted Spread
0.0329
1.19
R2 = 0.1143
Model 2
R2 = 0.1230
Coefficients
Tstat
Intercept
0.0008
1.77
Coefficients
Tstat
Intercept
0.0070
16.16
Dummy
0.0063
10.54
Dummy
0.0061
10.42
Realized Volatility
0.0396
11.44
Realized Volatility
0.0438
13.00
LIBOR1m
0.0227
1.77
LIBOR1m
0.0162
1.30
Ted Spread
0.0027
4.96
Ted Spread
0.0022
4.20
R2 = 0.0439
Model 3
25
R2 = 0.0518
Coefficients
Tstat
Coefficients
Tstat
Intercept
1.7142
12.23
Dummy
1.8545
9.79
Intercept
1.0573
7.85
Dummy
1.7408
Realized Volatility
4.7487
9.57
4.34
Realized Volatility
7.0858
LIBOR1m
6.75
7.7907
1.93
LIBOR1m
4.9535
1.28
Ted Spread
0.0858
0.51
Ted Spread
0.0781
0.48
Weights Model
Model 1
Model 2
Model 3
Weights Model
Model 1
Model 2
Model 3
26
Tstat
11.28
23.20
16.53
4.37
2.70
1.82
7.07
3.10
3.24
1.79
Tstat
10.24
19.78
21.63
5.27
3.72
1.51
6.75
1.74
0.12
1.78
Tstat
12.73
20.79
13.24
4.40
0.60
3.15
9.10
7.64
5.04
0.45
Tstat
4.30
12.75
9.81
2.94
0.12
0.14
5.74
1.96
1.22
2.29
Tstat
3.03
10.44
11.33
3.17
0.99
0.94
5.19
5.24
4.85
2.87
Tstat
5.76
9.36
8.00
3.17
3.15
1.54
7.71
2.01
1.29
0.47
Appendix A
Proof of Proposition 1: The liquidity demanders try to maximize their expected utility of t = 2,
by choosing the optimum value of 1d at t = 1. The liquidity demanders wealth at t = 2 will be
constitute of their wealth from t = 1 (i.e. W1 ) their capital gain from investing on the risky assets
(i.e. 1d (S2 S1 )) and the extra endowment zM(S2 S) that they receive at t = 2.
At t = 1, the liquidity demanders expectation about their final utility (i.e. U1d ) will be
U1d
= exp (W1 +
U1d
1d S1
+ zM S
= exp (W1 +
1d (S1
(1d
+ zM) S +
S) +
2 d
2 d
To maximize the expected utility in terms of the risky assets weights (i.e. 1d ), we must set the
corresponding derivative to zero.
27
U1d
1d
yields
= 0.
S1 S + 2 (1d + zM) = 0.
S1 S + (1d + zM) = 0.
1d + zM =
1 1
(S S1 ),
which gives the optimal holding of the liquidity demanders on the risky assets at t = 1.
1d =
1 1
(S S1 ) zM
Similarly one can show that the optimal holding of the liquidity suppliers on the risky assets is
1s =
1 1
(S S1 )
(1 ) 1
1
(S S1 ) zM +
(S S1 ) = ,
28
1 (S S1 ) = + zM.
Therefore the equilibrium prices at t = 1, will be
S1 = S ( + zM)
29
21 21
2 2 2
z diag ([21 22
21 23
21 22
22 22
23 22
21 23
21 21
2
2
2
23 22 ]) = z [22 22 ]
23 23
23 23
2 2 2z wi wj 2i 2j
i=1 j=1
Proof of Proposition 4: Given the results of Proposition 1 and 2, one can show,
1d = + ( 1)zM
30
1s = + zM
U1d
= exp (W1 +
1d (S1
S) +
2 d
W1
d
1 (S1 S)
U1d = exp
W0 0 (S S0 ( + zM))
2 ( + ( 1)zM) ( + zM)
(
2
( + ( 1)zM + zM) ( + ( 1)zM + zM)
2
+
2 d
( +zM) (d
1 +zM)
2 1
We define
Ad = W0 + 0 S 0 S0 0 +
2
31
Bd = 0 M (1 ) M
Cd = (2 2)M M
1
U1d = exp ( (Ad + Bd z + Cd z 2 ))
2
Fd
exp (Ad
U0d = [U1d ] =
Bd 2z
)
2 (1 + Cd 2z )
)
1 +
Cd 2z 
3 2z (0 M + (1 ) M)2
Fd = W0 + 0 S 0 S0 0 +
2
2 (1 + 2 2z (2 2)M M)
At t = 0 the investors are identical, and thereby, they all hold the market portfolio, (i.e. 0 = )
thus
3 2z ( M)2
Fd = W0 + S S0
2
2 (1 + 2 2z (2 2)M M)
Fd
3 2z ( M)(M)
= S S0
1 + 2 2z (2 2)M M
gives
32
2 s s
),
2 1 1
s1 (S1 S)
W1
U1s = exp
W0 0 (S S0 ( + zM))
2 ( + zM) ( + zM)
(
2
+ ( + zM) ( + zM) ,
2
2 s s
1
2 1
We define
As = W0 + 0 S 0 S0 0 +
2
Bs = ( 0 ) M
Cs = 2 M M
1
U1s = exp ( (As + Bs z + Cs z 2 ))
2
Fs
exp (As
U0s = [U1s ] =
Bs 2 2z
)
2 (1 + Cs 2z )
)
s
2
1 + C z 
3 2 2z (( 0 ) M)2
Fs = W0 + 0 S 0 S0 0 +
2
2 (1 + 2 2z 2 M M)
33
Again at t = 0 the investors are identical, and therefore they all hold the market portfolio, (i.e.
0 = )
Fs = W0 + S S0
2
Fs
= S S0
Before a liquidity shock occurs, we know that a population of the investors will be liquidity
demanders and the rest will be liquidity suppliers. Therefore the aggregate utility will be
U0 = U0d + (1 )U0s ,
To optimize the holding on the risky assets at t = 0, we must set the corresponding derivative to
zero, thus
U0
U0d
U0s
(1
=
+ )
= 0,
Fd
1
Fs
exp(Fd ) (
)+
exp(Fs ) ( ) = 0
1 + 2 2z (2 2)M M
1 + 2 2z 2 M M
1 + 2 2z 2 M M
Fd
Fs
))


exp((F
F
(
)
+
(
)=0
d
s
1 1 + 2 2z (2 2)M M
Fd Fs =
34
3 2z ( M)2
1 M
=
2(1 + 2 2z (2 2)M M)
20
Therefore,
1 + 2 2z 2 M M
2 1 M Fd
Fs

 exp (
)(
)+( )= 0
1
0
20
Fd
1 (M)
= S S0
0
Therefore,
1 + 2 2z 2 M M
2 1 M
1 (M)

 exp (
) (S S0
) + (S S0 )
1
0
20
0
=0
1+2 2z 2 M M
We define = 
2 1 M
 exp (
20
1 (M)
(S S0
) + (S S0 ) = 0
1
0
+ 1
1 (M)
(S S0 )
(
)=0
1
1
0
Which gives the risky assets equilibrium price at t = 0 with
35
S0 = S
( 1 )
0
1 +
0
For example if M = [1] then
0
1
)
0
S0i = Si 0,i ij
1 + i2
3
j=0
36
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38
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