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Comatose Markets: What if liquidity is not the norm? December 2010

Aswath Damodaran Stern School of Business

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Comatose Markets: What if liquidity is not the norm?

Much of financial theory and practice is built on the presumption that markets are liquid. In a liquid market, you should be able to but or sell any asset, in any quantity, at the prevailing market price and with no transactions costs. Using that definition, no asset is completely liquid and there are wide variations in liquidity across asset classes, across assets within each asset class, and across investors. After presenting evidence to back up this proposition and recognizing that investors care about and price in illiquidity, we evaluate how introducing illiquidity into the decision process not only alters portfolio composition but has a divergent impact on investors with different time horizons and investment strategies. The presence and pricing in of liquidity opens up profitable opportunities for two classes of investors: long-term investors who care about less about liquidity than the rest of the market (liquidity arbitrageurs) and investors who can time shifts in market liquidity (liquidity timers). In illiquid markets, firms will also be more sparing in their use of debt, will pay higher dividends, will buy back less stock and will accumulate more cash.

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Much of financial theory and practice is built on the presumption that liquidity is the norm and that illiquidity exists only in pockets, for a few stocks, in certain asset classes (real estate, collectibles) and in small, emerging markets. Thus, investors are advised to diversify across asset classes, largely ignoring differences in illiquidity across them, and to buy under valued assets within each one, notwithstanding the fact that some assets are much more illiquid than others. In corporate finance, almost of the discussion of how firms should pick investments, whether they should fund these investments with debt or equity, and how much they should pay in dividends largely ignores liquidity concerns. It is the during crises that we recognize the fragility of the liquidity assumption, as order imbalances bring trading to a halt on even the most widely traded securities and transactions costs mount for both investors and firms. Rather than view these bouts of illiquidity as aberrations, it is more prudent to accept them as a given and consider how best to incorporate the potential for illiquidity into both investment policy and corporate financial decisions.

Defining and Measuring Liquidity

In a world with perfect liquidity, you should be able to buy or sell an asset instantaneously at the prevailing market price and bear no transactions costs. Using that definition, no asset market is completely liquid and the degree of illiquidity can be measured in one of two ways. The first is in terms of transactions cost: the greater the costs associated with trading an asset, the less liquid that asset. The other is in terms of waiting to trade time: when an asset is illiquid, you have to wait longer to sell that asset and the wait time becomes a measure of illiquidity. The Transactions Cost Measure When trading most assets, the transactions cost that is most visible is the up front brokerage or trading cost. While this might be the only explicit cost that you pay for trading some assets, there are two other costs that you will incur in the course of trading other assets that can dwarf the commission cost. The first is the spread between the price at which you can buy an asset (the dealers ask price) and the price at which you can sell

4 the same asset at the same point in time (the dealers bid price). The second is the price impact you can create by trading on an asset, pushing the price up when buying the asset and pushing it down while selling. Brokerage Costs In most asset markets, the transactions cost takes the form of a brokerage cost at the time of the transaction. Since the function of the broker is to bring together a willing buyer and seller in a transaction, the cost of that intermediation will vary across assets and markets. In particular, it should be a function of the following: a. Standardization of product: A brokers job is made much easier by standardization. One share of IBM is exactly identical to any other share, thus eliminating the need for the broker to characterize or vouch for the product to potential buyers. In contrast, one real estate property is seldom identical to another property and brokers have to play the role of information providers. b. Depth and breadth of the market: The greater the number of investors trading in a product, the easier it will be for the broker to arrange a transaction. Therefore, you would expect brokerage costs to be smaller for treasury bonds than for collectibles or fine art. After all, there are few potential buyers for a painting by Picasso and the fees charged by auctioneers will reflect the cost associated with finding a buyer. c. Competition among brokers: As competition increases across brokers, the brokerage costs should decrease. The ending of fixed commissions for stock trading on Wall Street in 1975 opened up the market to discount brokerage houses and a dramatic drop in brokerage costs. As a consequence of differences on these dimensions, the brokerage cost will be much higher in some markets than others and include compensation for services beyond just intermediation, and even across assets within each market. The Bid-Ask Spread With traded securities, there is a difference between what a buyer will pay and the seller will receive, at the same point in time for the same asset. The bid-ask spread refers to the difference between the price at which you can buy and the one at which you can sell, and the spread is set by a dealer or market maker. There are three types of costs that

5 the dealer faces that this spread is designed to cover. The first is the cost of holding inventory, the second is the cost of processing orders and the final cost is the cost of trading with more informed investors. The spread has to be large enough to cover these costs and yield a reasonable profit to the market maker on his or her investment in the profession. 1. The Inventory Rationale Consider a market maker or a specialist on the floor of the exchange who has to quote bid prices and ask prices, at which she is obligated to execute buy and sell orders from investors. These investors, themselves, could be trading because of information they have received (informed traders), for liquidity (liquidity traders) or based upon their belief that an asset is under or over valued (value traders). In such a market, if the market makers set the bid price too high, they will accumulate an inventory of the stock. If market makers set the ask price too low, they will find themselves with a large short position in the stock. In either case, there is a cost to the market makers that they will attempt to recover by increasing the spread between the bid and ask prices. Market makers also operate with inventory constraints, some of which are externally imposed (by the exchanges or regulatory agencies) and some of which are internally imposed (due to limited capital and risk). As the market makers inventory positions deviates from their optimal positions, they bear a cost and will try to adjust the bid and ask prices to get back to their desired position. If the inventory is too high, the bid price is too high; if the inventory is too low or negative, the ask price is too low. 2. The Processing Cost Argument Since market makers incur a processing cost with the paperwork and fees associated with orders, the bid-ask spread has to cover, at the minimum, these costs. While these costs are likely to be very small for large orders of stocks traded on the exchanges, they become larger for small orders of stocks that might be traded only through a dealership market. Furthermore, since a large proportion of this cost is fixed, these costs as a percentage of the price will generally be higher for low-priced stocks than for high-priced stocks. Technology clearly has reduced the processing cost associated with trading securities as computerized systems take over from traditional record keepers.

6 These cost reductions should be greatest for stocks where the bulk of the trades are small trades - small stocks held by individual rather than institutional investors. 3. The Adverse Selection Problem The adverse selection problem arises from the different motives investors have for trading on an asset - liquidity, information and views on valuation. Since investors do not announce their reasons for trading at the time of the trades, the market maker always runs the risk of trading against more informed investors. Since the expected profits from such trading are negative, the market maker has to charge an average spread that is large enough to compensate for such losses. This theory would suggest that spreads will increase with the proportion of informed traders in an asset market, the differential information possessed, on average, by these traders and uncertainty about future information on the asset. The Price Impact Most investors assume that trading costs are less for large, institutional investors than for smaller, individual investors. While this is true for brokerage commissions and perhaps even for the bid-ask spread, it is not the case for the third component: larger investors bear more substantial costs than do smaller investors and that is in the impact that trading has on prices. Investors with large portfolios make larger buy and sell trades and have a much larger effect on stock prices as they trade, pushing up prices as they buy and down as they sell, reducing investment profits. There are two reasons for the price impact. The first is that markets are not completely liquid. A large trade can create an imbalance between buy and sell orders, and the only way in which this imbalance can be resolved is with a price change. This price change that arises from lack of liquidity, will generally be temporary and will be reversed as liquidity returns to the market. The second reason for the price impact is informational. A large trade attracts the attention of other investors in that asset market because if might be motivated by new information that the trader possesses. Notwithstanding claims to the contrary, investors usually assume, with good reason, that an investor buying a large block is buying in advance of good news and that an investor selling a large block has come into possession of some negative news about the company. Unlike the trading

7 imbalance effect, this price effect will not dissipate quickly, since investors will wait for confirmation. Waiting time as a measure of liquidity A seller, facing an illiquid market, has two choices. He can the cut the asking price and still try to sell the asset, thus increasing transactions costs, or he can wait for the market to become more liquid. This waiting time creates two costs for the seller. The first is time value, where the investor has to delay receiving the sales proceeds for weeks or even months. The second is that the keeping the asset and maintaining it in selling condition may create additional costs. There are two other risks to waiting to sell. First, the price of an asset that an investor wants to sell may fall further while the investor waits to trade, and this, in turn, can lead to one of two consequences. One is that the investor does eventually sell, but at a much lower price, reducing expected profits from the investment. The other is that the price falls so much that the asset that the investor does not trade at all. A similar calculus applies when an investor wants to buy an asset that he or she thinks is undervalued. In many real asset markets, illiquidity is more likely to manifest itself in extended waiting times than in higher transactions costs, for a variety of reasons. First, sellers may be psychologically more willing to bear waiting costs than take a price cut; thus, a person trying to sell his residence may feel less pain waiting two years to sell the property than taking a price cut of 15%, even though the financial impact may be the same. Second, the financing structure of some real assets may push sellers to wait rather than sell. Again, using real estate as the example, mortgages are tied to individual properties; if a property is sold at a price well below the mortgage due, the borrower will have to come up with the cash to cover the difference. In real estate, a statistic that is tracked and reported is days on market (DOM), measuring the number of days a typical listed property has been on the market. This statistic can be used to measure not only variations in liquidity across geographical areas but also across time.

Why does liquidity matter?

Before discussing how to measure liquidity and the evidence on illiquidity in markets, it is important that we establish why we care. As we will see in this section,

8 much of financial theory is predicated on the assumption that assets are liquid or that the costs of illiquidity are small. Asset Pricing & Valuation There are three approaches that can be used to value an asset and we make implicit assumptions about liquidity in all three. a. In intrinsic valuation, we value an asset by discounting expected cash flows back at a risk adjusted discounted rate. In computing expected cash flows, we implicitly consider probability-weighted averages of cash flows under different scenarios, but we dont consider the fact that there may be more liquidity under some scenarios than in others. Thus, cash flows in good economic times, when funds are easy to access, is treated the same as a cash flow of $ 100 million in bad times, when funds are more likely to be constrained. When computing risk adjusted discount rates, if we follow conventional financial theory, we estimate the riskiness of an asset by looking at the market risk in that asset (captured by a beta or betas) and a market wide risk premium for that risk (equity risk premium). Nowhere in the computation is a consideration of the fact that some investments may be more liquid than others and that the illiquidity can generate a cost for investors in the future. b. In relative valuation, we value an asset by looking at how similar assets are priced by the market. Here again, there is little consideration given to liquidity. Holding all else constant, a stock that trades at a price earnings ratio of 12 is viewed as cheap if other equities that share its characteristics (same sector, growth rate) trade at higher price earnings ratio. The fact that the cheap stock is lightly traded is at best treated as an after thought and at worst, completely ignored. c. In contingent claim valuation, we draw on established option pricing models, such as the Black-Scholes and the binomial. Though these models are elegant, they are based upon the implicit assumption that assets are liquid and that transactions costs are negligible. The problem is magnified when we treat undeveloped natural resource reserves, pharmaceutical or technological patents and opportunities to expand into large markets as real options, where the underlying assets are not traded and liquidity is a mirage.

9 If we accept the premise that liquidity varies both across assets, and illiquidity creates costs for investors, it stands to reason that using conventional valuation models will attach too high a value for illiquid assets. If overall market liquidity can change over time, not adjusting for those changes will lead us to find entire markets to be under valued during crisis periods. Finally, if some investors care more about illiquidity than others, failing to incorporate the illiquidity cost into value will lead us to ignore the reality that the same asset can be valued differently by different investors, especially during periods of market illiquidity. Practitioners have developed tweaks within each of these approaches to allow for illiquidity. Appraisers who use discounted cash flow models to value private businesses generally apply a significant illiquidity discount to their estimated values, to allow for the fact that private businesses are not traded. Equity research analysts will sometimes factor in the trading volume and bid-ask spreads when comparing the pricing of companies within their peer groups and there are variants on conventional option pricing models that bring in illiquidity costs into the estimate. The adjustments to conventional models, though, have tended to be ad hoc and often arbitrary, with wide divergences in practice. Portfolio Management Since Harry Markowitz laid out the rationale for diversification and presented his argument that a diversified portfolio will generate a much better risk/return trade off than an undiversified one, financial theorist have preached the mantra of diversification to investors and argued that diversified portfolios offer the best risk/return tradeoff. However, following Markowitz, we have also defined risk as the standard deviation or volatility in stock prices and paid no explicit attention to liquidity risk and its consequences for investing. Asset Allocation In conventional portfolio theory, asset allocation is a function of an investors risk aversion and the market timing abilities. If investors are not good at timing markets, and the preponderance of the evidence suggests that they not, they should diversify across asset classes, based upon the expected return and the standard deviation of each asset class as well as the covariances across them, to find the mix that delivers the highest

10 expected return for any desired level of risk. If investors have the capacity to time markets, they can alter this mix to reflect their views on which markets are cheap (and will out perform) and which ones are expensive. In this algorithm for maximizing returns, though, our measures of standard deviation and covariance are derived from past data and there is the implicit assumption that all asset classes are equally liquid. This assumption is what allows up to use expected returns, standard deviations and covariances from past data and use these numbers as inputs into the asset allocation decision. If there are differences in liquidity across asset classes, there is little in the optimization process that incorporates these differences; lower liquidity does not always manifest itself in higher standard deviations. In fact, as trading volume and liquidity in an asset market decreases, the standard deviation usually drops, making illiquid assets look less risky. Depending on these variances to make asset allocation judgments will lead investors to over invest in illiquid asset classes, as did many pension funds and portfolio managers who invested in private equity and real estate in 2007 and 2008. Security Selection The optimization process used to allocate a portfolio across asset classes, based upon maximizing expected returns for any given level of risk is extended when we select assets within each asset classes. With stocks, for instance, the expected returns on individual stocks, in conjunction with the variance-covariance matrix across these stocks, is used to determine which stocks to hold and in what proportions. Here again, though, the failure to explicitly control for liquidity differences across assets can lead investors to invest too much in less liquid stocks. Even portfolio managers who dont use optimization techniques make their investment choices without explicitly considering illiquidity. Consider, for instance, a strategy of investing in small market cap companies with low price earnings. While studies back up the notion that this is a winning strategy in the long term, what these studies fail to consider is the additional transaction cost burden faced by investors in these companies; small companies tend be less liquid and create more transactions costs for their owners in the form of higher bid-ask spreads and larger price impact.

11 Finally, the argument that investors in most publicly traded firms should hold dispersed portfolios is conditioned on the assumption that the transactions costs of diversifying are low. If investments are illiquid, and diversification is therefore expensive, it is entirely possible that the advice has to be modified to allow for the trade off between diversification and transactions costs. Market Efficiency Since financial market theorists posited the notion of an efficient market, there has been tension in portfolio management between those who believe that markets are efficient and that active portfolio management is pointless, and those who argue that active portfolio management can deliver results because markets are inefficient. The question of whether markets are efficient is an empirical one and there are literally hundreds of studies that try to answer this question by testing out the viability of investment strategies that claim to beat the market. In fact, it is the results from these studies that have provided ammunition to those who argue that markets are not efficient. If these studies are to believed, the list of characteristics that can be mined to generate profits seems endless: small market cap companies, low priced stocks, companies with high dividend yields and low price to book ratios and companies with earnings/price momentum all seem to deliver higher returns than they should. However, most of these studies also pay only lip service to transactions costs and provide little more than the platitude that the excess returns look too large to be explained by transactions costs or lack of liquidity. However, the congruence between stocks that look cheap in these studies and illiquidity is too high to be a coincidence. It is also a testimonial to the presence of transactions costs (and illiquidity) that so few portfolio managers who adopt these beat-the-market schemes actually end up beating the market. Believers in efficient markets face a friction of their own, when it comes to liquidity. If markets are truly efficient and investors came to that acceptance, they would invest in passive portfolios or index funds.1 If they did so, there would be little or no

Grossman, S. J. and J.E. Stiglitz, 1980, On the Impossibility of Efficient Markets, American Economic Review, v70, 393-408.

12 trading, markets would become illiquid, and market inefficiencies would become commonplace. Leverage in Investment Strategies Investors can augment the returns that they make on investments by using borrowed money to fund them. Conventional financial theory bases how much you should borrow to the riskiness of the investments that you are funding. At one extreme, you can borrow 100% of your investment, if you are investing in a riskless asset. That is, in fact, the basis for arbitrage, where you invest none of your money (since all of it is borrowed), take no risk (since the returns are guaranteed) and make more than the risk free rate (the arbitrage). Option pricing and futures pricing models are built on this strategy. As the riskiness of the assets increases, the amount you can borrow to fund those assets should decrease. Nowhere in this process is liquidity explicitly considered. To the extent that even a riskless investment may be illiquid during the investment period, borrowing 100% to fund that investment can be catastrophic for an investor who is forced to exit the strategy early. Common sense suggests that liquidity has to be explicitly considered when deciding on the right amount of financial leverage to fund that strategy, with leverage decreasing as illiquidity increases. Types of investment strategies Investment strategies can be short term or long term, be based upon information or value judgments, or can be momentum or contrarian in nature, and the dependence on liquidity varies widely across strategies: 1. Is the valuation assessment based upon private information or is based upon public information? Private information tends to have a short shelf life in financial markets, and the risks of sitting on private information are much greater than the risks of waiting when the valuation assessment is based upon information that is already public. Thus, the capacity to trade quickly and with minimal price impact looms much larger when the strategy is to buy on the rumors (or information) of a possible takeover than it would be in a strategy of buying low PE ratio stocks.

13 2. How active is the market for information? Building on the first point, the effect of illiquidity, when one has valuable information, is much greater in markets where there are other investors actively searching for the same information. Again, in practical terms, the importance of liquidity is greater when there are dozens of analysts following the targeted stock or investment than when there are few other investors paying attention to the stock. 3. How long term or short term is the strategy? While this generalization does not always hold, short-term strategies are much likely to be affected by illiquidity than longer term strategies. Part of the reason is that short term strategies, by definition, will lead to more trading, and thus a greater exposure to transactions costs (and illiquidity). It is also likely that short term strategies are more likely to be motivated by private information, whereas long term strategies are more likely to be motivated by views on value. 4. Is the investment strategy a contrarian or momentum strategy? In a contrarian strategy, where investors are investing against the prevailing tide (buying when others are selling or selling when others are buying), the importance of liquidity is likely to be smaller precisely because of this behavior. In contrast, the effects of illiquidity in a momentum strategy are likely to be higher since the investor is buying when other investors are buying and selling when others are selling. In summary, the costs of illiquidity are likely to be greatest for short-term investment strategies, based upon private information or momentum, and in markets with active information gathering. It will be less of an issue for long-term investment strategies based upon public information and for contrarian strategies. Corporate Finance The belief that markets are liquid also underlies corporate financial theory. In capital budgeting, capital structure and dividend policy, much of what we propound as good corporate finance practice is built on the presumption of liquid markets for both financial and real assets.

14 Investment Policy Every firm has to make resource allocation decisions; determining which investments to take and which ones to reject is a key component of running any business. If the objective in decision-making is to maximize the value of the firm, the way we assess projects has to be consistent with that objective. In this section, we will argue that every component of investment/project analysis makes implicit or explicit assumptions about liquidity. Investment Decision Rules In the last four decades, we have seen a shift away from accounting profitability measures to cash flow based decision rules. Thus, rather than assess projects on the basis of return on investment or return on equity, corporate financial theorists have argued that we make better decisions by considering cash flows (rather than earnings) and discounting these cash flows back to the present, using a risk-adjusted discount rate (a cost of equity or capital). While the shift from accounting earnings to cash flows is a good one, consider the two basic discounted cash flow rules that are generally used in capital budgeting. The first is the net present value, computed as the sum of the present values of expected cash flows on an investment over its life. The other is the internal rate of returns, the discount rate that results in a zero net present value. Most corporate finance textbooks go on to conclude that the net present value rule is superior to the internal rate of return rule because it is more consistent with value maximization.2 In fact, a business should take every positive net present value investment it is faced with, if it wants to maximize its value. This conclusion, though, is true only if firms have unlimited access to fairly priced capital. Put differently, the transactions costs (including price impact) of raising new debt and equity capital have to be zero or close to zero. In fact, it is easy to show that as the cost of accessing capital increases, it is no longer be sensible or rational for a firm to invest in every positive net present value investment.

There are two other side benefits that are offered for the net present value rule over the internal rate of return rule. The first is that there can be only one net present value for an investment, whereas there can be multiple internal rates of return. The other is that the internal rate of return is based on the assumption that cash flows can be reinvested at the internal rate of return, whereas the net present value is based on the more sustainable assumption that cash flows get reinvested at the cost of capital.

15 Cash flows (on liquid versus illiquid assets) In most conventional cash flow computations, we start with earnings and net out reinvestment needs to get to cash flows. Thus, we assume that the firm will be able to use these cash flows as it sees fit; it can invest the cash flow in other projects, hold it as a cash balance or draw on it to pay dividends and service debt. While this may be a reasonable assumption in some cases, it may not in the following circumstances: a. Regulatory Restrictions: In some regulated businesses, cash flows that are generated may need to be held in the business to meet regulatory constraints. Thus, a bank that has excess cash flows may be unable to pay that cash out, if the payout will reduce its equity capital below a regulatory requirement. b. Dividend/Book Value Restrictions: Some countries have restrictions not only on how much can be paid in dividends but also on book value. In many European markets, companies are required to maintain a positive book value for equity and dividends or buybacks that cause book value of equity to drop below zero are not allowed. c. Debt covenants: When firms borrow money, lenders often attach covenants to the loans that can restrict how the firm uses its cash flows. For instance, a firm may be required to hold a minimum cash balance (rather than pay it out) or use the cash to bring working capital up to a specified level. d. Sovereign remittance restrictions: As companies expand into emerging markets, looking for growth, they are also increasingly exposed to restrictions that some countries impose on repatriating the cash flows back to the parent entity. In some cases, companies are required to reinvest the cash back into those countries and in other cases, there are restrictions on how much cash can be repatriated in any period. e. Exchange rate effects: When cash flows in a foreign currency have to be converted into domestic currency cash flows, we have to make assumptions about exchange rates in the future. With liquid currencies, we can obtain these expected rates by looking at forward or futures markets but with illiquid currencies where forward/futures rates are unavailable, we not only have to estimate expected

16 future rates but also assume that the markets will be liquid enough for this conversion to occur in the future. The net effect of these restrictions is that what we compute as cash flow may not match up to a liquid cash flow. When we treat all cash flows equivalently, we are also assuming that none of these restrictions are binding. Cost of equity and capital Reviewing first principles in investment analysis, the discount rate for the cash flows can be a cost of equity (if the cash flows are post-debt cash flows) or a cost of capital. In making these estimates, though we generally consider do not consider the liquidity risk in raising either equity or debt. We compute the cost of equity by looking at the market risk in the equity investment and the cost of debt based upon default risk, and ignore the costs that can be created by illiquidity in either market. How would illiquidity manifest itself in these costs? If a market is illiquid, there will be flotation or issuance cost that will be substantial and incorporating this cost will raise the cost of all financing. Thus, if the issuance cost for new equity is 10% of the proceeds, the cost of equity will have to be higher to cover this issuance cost. By ignoring illiquidity, we are understating the costs of equity and capital for all firms but more so for smaller firms that face more costs in raising capital and emerging market firms that operate in illiquid markets. Across time, we are understating costs of equity and debt during times of crisis, when illiquidity increases across the board for all firms, and again more so for some firms than others. Capital Structure Every firm faces a trade off between using owners funds (equity) or borrowed money (debt), when funding investments. Debt provides significant tax advantages, since interest expenses are fully tax deductible whereas cash flows to equity (dividends, buybacks) have to come out of after-tax cash flows. However, debt also increases the likelihood of default and bankruptcy, while also exacerbating agency problems: what is good for equity investors may not be good for lenders who respond by restricting the firm through covenants. While this trade off, by itself, is unaffected by illiquidity, the tools we

17 use to arrive at the optimal mix of debt and equity are affected by our assumptions on liquidity. How much debt to use One technique that is used to assess the optimal mix of debt and equity for a company is to find the mix of debt and equity that minimizes the cost of capital. In the last section, we noted how ignoring liquidity can result in the costs of equity, debt and capital being understated for all firms, and more so for firms that face difficulty accessing capital markets and during periods of market illiquidity. To the extent that illiquidity affects both debt and equity markets equally, the approach will still work, even if we do not incorporate the effects of illiquidity into the cost of capital. However, if illiquidity is more of problem in one market than the other, using the cost of capital to arrive at an optimal debt mix will yield a misleading result. Thus, if equity markets are illiquid but bank lending is easier to access, the cost of capital approach will generate an optimal debt ratio that is too low, relative to the true optimal. If the reverse applies, i.e., equity markets are liquid but debt markets are costly to access, the cost of capital approach will yield too high an optimal debt ratio. The other approach uses to come up with the optimal financing mix is the adjusted present value approach, where the value of debt is assessed by adding the tax benefits of debt to the value of the firm with no debt and then subtracting out the expected bankruptcy costs. The expected bankruptcy costs can be affected by illiquidity on two dimensions: The probability of bankruptcy reflects the likelihood that the firm will be unable to meet an obligated debt payment. Holding all else constant, the more illiquid a market is, the greater is the likelihood that bad times will lead to default. In a liquid market, even troubled firms may be able to raise fresh capital to ward off default, whereas this option is less accessible in an illiquid market. The cost of bankruptcy measures how much the firm will lose as a consequence of default. Assuming that the assets of the firm will be sold to cover its unpaid obligations, the cost of distress will be lower, if asset markets are liquid. If asset

18 markets are not liquid, a distressed firm will have to sell its assets at a much bigger discount. If we ignore illiquidity in making capital structure choices, as we often do, it is entirely possible that the optimal debt ratios that we estimate will be incorrect, and more so for small market cap and private firms that are more exposed to illiquidity. Type of Debt Assuming that you have arrived at the right mix of debt and equity for your firm, you have to decide on the type of debt to take short term or long term, dollar or euro, fixed or floating and straight or convertible. The conventional corporate finance principle on this choice is simple: match the debt you take to the assets you fund with the debt. Thus, long-term dollar debt should be used to fund a long-term project that generates cash flows in dollars. The rationale for this approach is reduced default risk: you are less likely to default if the cash flows on your debt match up to the cash flows on your assets. How does liquidity play into this decision? The matching principle will fail if there are significant differences in liquidity across different types of debt and variations in liquidity over time. Thus, a firm with a project in Indonesia may choose to use dollar debt to fund the rupiah cash flow project because rupiah bonds are significantly less liquid than dollar denominated bonds. In a market where liquidity varies over time, firms may decide to borrow long term during periods of high liquidity, even if their projects are short term, so that they are not exposed to the risk of having to access markets during periods of low liquidity. In effect, the choice of debt becomes a trade off between the costs of illiquidity and the costs of mismatching debt to assets. Dividend Policy The final piece of the corporate finance analysis confronts two questions: How much cash should a firm return to its stockholders each period? What form of cash return, dividends or stock buybacks, is the right one to use? In answering these questions, we do make implicit assumptions about liquidity.

19 How much to return to stockholders? The basic principle that underlies dividend policy in conventional corporate finance is that if a firm cannot find investments that generate a return that exceeds its cost of capital, it should return that cash to its stockholders. Extending that principle, there is also little need for a cash balance, beyond what the firm needs to meet its operating requirements. This conclusion, of course, though is built on the presumption that capital markets are liquid and accessible and that this firm will be able to go out and raise capital in future periods to cover any good investments that it may encounter. To the extent that equity markets or debt markets are illiquid, the recommendations to return whatever excess cash you have to stockholders and maintain a minimal cash balance have to be modified. In general, as the cost of accessing capital markets increases, the need to maintain a cash balance to meet future investment needs will also increase and the capacity to return cash to stockholders will decrease. Dividends versus Stock buybacks The question of whether to pay dividends or buy back stock has generally been framed around the tax issue. If investors are taxed more heavily on dividends than capital gains, it has been argued that stock buybacks will generate more value for investors. Since the tax rate on dividends has historically increased with wealth level, this would suggest that companies with wealthy investors should pay less in dividends and buy back more stock.3 There is, however, also a liquidity difference. Dividends represent cash in the hand for investors who get them. Stock buybacks, however, require that you be able to either tender your shares in the buy back or sell your shares in the after market to collect your capital gains. To the extent that markets are illiquid, stock buybacks can be viewed as less liquid cash flows than dividends. Thus, if markets become more illiquid, a company that has planned to return cash to its stockholders may be more inclined to return them as dividends rather than buy back shares.

In 2003, the tax law was changed to set taxes on dividends equal to the tax on capital gains. Prior to that, investors paid their marginal ordinary tax rate on dividends, whereas the capital gains tax rate was fixed. Wealthier investors paid 40%, 50% or more on dividends while paying 20% or so on capital gains.


Evidence on Liquidity
As we noted in the introductory section, illiquidity can be measured in one of two ways, transactions costs from trading or the waiting time to trade. In this section, we will examine the empirical evidence on the differences in liquidity across markets but also within markets, both across individual assets and across time. We also look at the cost of illiquidity by looking at what investors demand as compensation for buying illiquid assets. The extent of illiquidity Most of the empirical evidence accumulated over time looks at the transactions costs of trading. Not surprisingly, researchers find big difference in liquidity across asset classes, with financial asset markets generally being more liquid that real asset markets. With each market, liquidity varies widely across individual assets and over time. Across Asset Classes and Markets As we noted earlier, in the last two decades, investors have been advised to add real estate, emerging market stocks, commodities and other real assets to their portfolios, and to invest in hedge funds and private equity portfolios, many of which hold non-traded companies and assets. While the risk/return trade off can look alluring, there are also significant liquidity differences across asset classes and markets. Generally speaking, financial assets are the most liquid asset class, partly because they are sold in standardized, small units and partly because there are more traders in the markets. Even within financial assets, though, there are differences, with the most liquid market being the one for US treasuries, where the depth and width of the market generates miniscule bid-ask spreads and instantaneous execution. For instance, the typical bid-ask spread on a Treasury bill is less than 0.1% of the price. The spreads on corporate bonds tend to be larger than the spreads on government bonds, with safer (higher rated) and more liquid corporate bonds having lower spreads than riskier (lower rated) and less liquid corporate bonds. Stocks in developed markets are, for the most part, liquid, but the degree of liquidity varies across stocks and across time. The spreads in emerging equity markets are higher than the spreads on U.S. markets, reflecting the lower liquidity in those markets and the smaller market capitalization of the traded firms.

21 If the cost of trading securities can be substantial, it is even more significant for assets that are not traded regularly such as real assets or equity positions in privately owned businesses. Real assets can range from commodities to real estate to fine art and the transactions costs associated with trading these assets can also vary substantially. The smallest transactions costs are associated with precious commodities gold, silver or diamonds since they tend to come in standardized units and are traded on commodity exchanges. In real estate, transactions cost can be a significant proportion of the real estate property value, with the brokers on the seller and buyer side splitting the difference. In residential real estate, the costs tend to be at the higher end of the scale, ranging from 4-6% of housing value for just the brokerage fees, with legal and other transactions costs adding to that number. In commercial real estate, where property values tend to be higher, the brokerage costs tend to be a lower proportion of property value, with other transactions costs again adding to the mix. With real estate, in particular, the stated commission costs understate the true costs because they ignore two other costs; the price impact from having to sell a property quickly or the cost of waiting to sell a property, in a down market. The trading costs associated with buying and selling a private business can range from substantial to prohibitive, depending upon the size of the business, the composition of its assets and its profitability. There are relatively few potential buyers and the search costs associated with finding these buyers will be high. Later in this paper, we will look at the conventional practice of applying 20-30% illiquidity discounts to the values of private businesses under the microscope. The difficulties associated with selling private businesses can spill over into smaller equity stakes in these businesses. Thus, private equity investors and venture capitalists are exposed to the potential illiquidity of their private company investments. Investors in private equity funds were made painfully aware of illiquidity costs, when some of them tried to liquidate their positions in the aftermath of the market crisis in 2008.4 In summary, liquidity can and will vary widely

College endowments, in particular, took a hit, when they tried to liquidate private equity investments in 2009. Harvard and Dartmouth University, which had moved a significant part of their overall endowment into private equity funds and real estate in the 2005-2007 time period lost significant portions of their funds, as they tried to liquidate their holdings after the market crisis in 2008.

22 across asset classes and markets and the resulting costs have to be considered while investing in them. Within asset classes Within each asset class, there can be wide variations in liquidity and transactions costs across individual assets. Thus, while equities and corporate bonds in the United States are collectively liquid, there are individual stocks and classes of bonds that are illiquid. Even within other asset classes, such as real estate and private equity, some properties and private equity funds are more liquid than others. In this section, we will focus on differences in liquidity across stocks within the US equity market to illustrate this phenomenon. US Equities As we noted in the first section, there are three components to transactions costs: brokerage costs, bid-ask spreads and price impact. The differences across stocks are smallest on the first component, but are much larger on the latter two components. Interestingly, while small investors bear a bigger burden than larger investors on brokerage costs and arguably on bid-ask spreads, they operate at an advantage to larger investors on the price impact; a large institutional investor will create more of a price impact when trading than a small individual investor. a. Brokerage costs The differences across stocks are smallest on the first component brokerage costs at least in absolute terms. Thus, the $8.95 you pay as a brokerage commission for trading shares on a discount brokerage service will be a smaller percent of your overall investment, if you buy 1000 shares instead of 100, or buy shares at $100/share rather than at $ 10/share. That being said, there are three dimensions, where your costs can vary across trades. The first is that the brokerage cost will be higher as a percent of your investment for lower-priced stocks than for higher priced one. The second is that odd lots will create larger transactions costs than even lots (of 100, 1000 etc). The third is that the brokerage costs will be higher for buying stocks listed and traded on foreign markets than on domestic ones.

23 b. Bid-ask spreads The medina bid-ask spread was $0.03 of the price for stocks listed on the New York Stock Exchange, which worked out to 0.113% of the stock price in 2005. On the NASDAQ, the median spread was a little higher at $0.046, estimated to be 0.22% of the stock price, in 2005. This average, however, obscures the large differences in the cost as a percentage of the price across stocks, based upon capitalization, stock price level and trading volume. A study5 by Thomas Loeb in 1983, for instance, reported the spread for small orders as a percentage of the stock price for companies as a function of their marker capitalization. These results are summarized in Figure 1:
Figure 1: Prices and Spreads by Market Cap
$60.00 7.00%



5.00% $40.00 4.00% $30.00 3.00% $20.00 2.00% $10.00


$0.00 Average Price Average Spread Spread/Price

Smallest $4.58 $0.30 6.55%

2 $10.30 $0.42 4.07%

3 $15.16 $0.46 3.03%

4 $18.27 $0.34 1.86%

5 $21.85 $0.32 1.46%

6 $28.31 $0.32 1.13%

7 $35.43 $0.27 0.76%

8 $44.34 $0.29 0.65%

Largest $52.40 $0.27 0.52%


Market Capitalization Class Average Price Average Spread Spread/Price

While the dollar spread is not that different across market capitalization classes, the smallest companies also tend to have lower priced stocks. Consequently, the spread is as high as 6.55% of the price, for small capitalization stocks and as low as 0.52% of the price for large capitalization companies. Another study by Huang and Stoll found that the stocks in the top 20% in terms of trading volume had an average spread of only 0.62% as a percent of the market price while the stocks in the bottom 20% had a spread of 2.06%.

See Trading Costs: The Critical Link Between Investment Information and Results in the Financial Analysts Journal, May/June 1983.

Spread as % of Price

Price & Spread


are also large differences in bid-ask spreads across different exchanges in the

United States. Looking at only NASDAQ stocks, Kothare and Laux (1995) found7 that the average was almost 6% of the price in 1992, and much higher for low-price stocks on the exchange. Some of the difference can be attributed to the fact that NASDAQ stocks are generally much smaller (in terms of market capitalization) and riskier than stocks listed on the NYSE or AMEX. You could argue that these studies are dated and that there have been significant changes in both the way markets are structured and spreads are set in financial markets. In particular, after studies found that spreads on the NASDAQ might have been manipulated by specialists, there was significant legal pressure brought on the exchange to alter the way in which spreads were set. This was followed by the New York Stock Exchange shifting from a long tradition of quoting spreads in 1/16 and 1/8 to decimals. Have these changes made a dramatic difference? On average, spreads have declined but the drop has been much greater for smaller, less liquid stocks. A number of studies have looked at the variables that determine (or, at the very least, correlate with) the bid-ask spread. Studies find that the spread as a percentage of the price is correlated negatively with the price level, volume and the number of market makers, and positively with volatility.8 Each of these findings is consistent with the theory on the bid-ask spread. The negative correlation with price level can be explained by the higher processing cost as a percentage of the price. Higher volume reduces the need for market makers to maintain inventory and also allows them to turn over their inventory rapidly, resulting in lower inventory costs. The higher volatility leads to higher bid-ask spreads partly because the adverse selection problem is greater for more volatile stocks; there will generally be more informed traders, a greater information differential and greater uncertainty about future information on these stocks. It is also worth noting

Huang, R. and H.R. Stoll. 1987. The Components of the Bid-Ask Spread: A General Approach, Review of Financial Studies, v10, 995-1034. 7 See Trading Costs and the Trading Systems for NASDAQ stocks by M. Kothare and P.A. Laux in Financial Analysts Journal (March/April 1995) 8 See Competition and the Pricing of Dealer Service in the Over-the-Counter Market by S.Tinic and R. West in Journal of Financial and Quantitative Analysis (June 1972), The Pricing of Security Dealer Services: An Empirical Analysis of NASDAQ stocks by H. Stoll in Journal of Finance (November 1978) and Jegadeesh, N. and A. Subrahmanyam, 1993, Liquidity Effects of the Introduction of the S&P 500 Futures Contract on the Underlying Stocks in Journal of Business (April 1993). V66, 171.187.

25 that variables such as price level, volatility and trading volume are not only correlated with each other, but are also correlated with other variables such as firm size. The study by Kothare and Laux, that looked at average spreads on the NASDAQ also looked at differences in bid-ask spreads across stocks on the NASDAQ. In addition to noting similar correlations between the bid-ask spreads, price level and trading volume, they uncovered an interesting new variable. They found that stocks where institutional activity increased significantly had the biggest increase in bid-ask spreads. While some of this can be attributed to the concurrent increase in volatility in these stocks, it might also reflect the perception on the part of market makers that institutional investors tend to be informed investors with more or better information. Note, though, that institutional investors also increase liquidity which should reduce the order processing cost component of the bid-ask spread, and in some cases the net effect can lead to a lower spread.9 Can firms have an effect on the bid-ask spreads that their stock trades at? There is some evidence that they can by improving the quality of information that they disclose the financial markets, thus reducing the advantages that informed traders may have relative to the rest of the market. Heflin. Shaw and Wild (2001) look at 221 firms and examine the relationship between information disclosure quality they measure this using disclosure quality scores assigned by the Corporate Information Committee of the Financial Analysts Federation and the bid-ask spread. They find that bid-ask spreads decrease as information quality increases.10 Frost, Gordon and Hayes (2002) extend the analysis to compare liquidity across different equity markets and find that markets with strong disclosure systems also have the most liquidity.11 While most of the studies quoted above have looked at differences in spreads across stocks, Hasbrouck (1991) investigated why spreads change for the same stock at different points in time. He notes that large trades cause spreads to widen, relative to

Dey, M.K, and B. Radhakrishna, 2001, Institutional Trading, Trading Volume and Spread, Working Paper. They provide evidence of the link between institutional trading and the spread for stocks listed on the NYSE. 10 Heflin, F., K.W. Shaw and J.J. Wild, 2001, Disclosure Quality and Market Liquidity, Working Paper, SSRN. 11 Frost, C.A., E.A. Gordon and A.F. Hayers, 2002, Stock Exchange Disclosure and Market Liquidity: An Analysis of 50 International Exchanges, Working Paper, SSRN.

26 small trades, and hypothesizes that this is because large trades are more likely to contain information.12 c. Price Impact Studies of the price reaction to large block trades on the floor of the exchange conclude that prices adjust within a few minutes to such trades. An early study examined the speed of the price reaction by looking at the returns an investor could make by buying stock right around the block trade and selling later13. They estimated the returns after transactions as a function of how many minutes after the block trade you traded, and found that only trades made within a minute of the block trade had a chance of making excess returns. (See Figure 2) Put another way, prices adjusted to the liquidity effects of the block trade within five minutes of the block. While this may be understated because of the fact that these were block trades on large stocks on the NYSE, it is still fairly strong evidence of the capacity of markets to adjust quickly to imbalances between demand and supply.


Hasbrouck, J., 1991, Measuring the Information Content of Stock Trades, Journal of Finance, v46, 179207; Hasbrouck, J., 1991, The Summary Informativeness of Stock Trades: An Economic Analysis, Review of Financial Studies, v4, 571-595. 13 Dann, L.Y., D. Mayers, and R. J. Rabb1977,Trading Rules, Large Blocks and the Speed of Price Adjustment, The Journal of Financial Economics, 4, 3-22.


Figure 2: Annualized Returns from buying after block trades


Annualized Return (net of transactions costs)


50% Block size =100K Block size =50K Block Size =10K 0% 0 1 5 10 15


-100% Minutes after the Block Trade

Source: Dann, Mayers and Rabb (1977)

This study suffers from a sampling bias - it looks at large block trades in liquid stocks on the exchange floor. Studies that look at smaller, less liquid stocks find that the price impact tends to be larger and the adjustment back to the correct price is slower than it is for the more liquid stocks.14 There are other interesting facts about block trades that have emerged from other studies. First, while stock prices go up on block buys and go down on block sells, they are far more likely to bounce back after sell trades. In other words, when prices go up after a block buy, they are more likely to stay up.15 A study by Spierdijk, Nijman, and van Soest (2002) that looked at both liquid and illiquid stocks on the NYSE also finds a tendency on the part of markets to overshoot. When a block buy is


Joel Haasbrouck looked at a detailed data set that contained information on quotes, trades and spreads of stocks listed on the NYSE and came to this conclusion. 15 See Holthausen, R. W., R. W. Leftwich, and D. Mayers, 1990, Large-Block Transactions, the Speed of Response, and Temporary and Permanent Stock-Price Effects," Journal of Financial Economics, 26, 71-95. and Keim, D. B., and A. Madhavan, 1995, Anatomy of the Trading Process: Empirical Evidence on the Behavior of Institutional Trades," Journal of Financial Economics, 37, 371-398.

28 made, the price seems to go up too much and it can take several days for it to revert back to a normal level for illiquid stocks.16 These studies, while they establish a price impact, also suffer from another selection bias, insofar as they look only at actual executions. The true cost of market impact arises from those trades that would have been done in the absence of a market impact but were not because of the perception that it would be large. In one of few studies of how large this cost could be, Thomas Loeb collected bid and ask prices from specialists and market makers, at a point in time, for a variety of block sizes. Thus, the differences in the spreads as the block size increases can be viewed as an expected price impact from these trades. Table 1 summarizes his findings across stocks, classified by market capitalization: Table 1: Round-Trip Transactions Costs as a Function of Market Capitalization and Block Size
Dollar Value of Block ($ thoustands) Sector 5 25 250 500 1000 2500 5000 10000 20000

Smallest 17.30% 27.30% 43.80% 2 3 4 5 6 7 8 Largest 8.90% 5.00% 4.30% 2.80% 1.80% 1.90% 1.90% 1.10% 12.00% 23.80% 33.40% 7.60% 5.80% 3.90% 2.10% 2.00% 1.90% 1.20% 18.80% 25.90% 30.00% 9.60% 5.90% 3.20% 3.10% 2.70% 1.30% 16.90% 25.40% 31.50% 8.10% 4.40% 4.00% 3.30% 1.71% 11.50% 15.70% 25.70% 5.60% 5.60% 4.60% 2.10% 7.90% 7.70% 6.20% 2.80% 11.00% 16.20% 10.40% 14.30% 20.00% 8.90% 4.10% 13.60% 18.10% 5.90% 8.00%

The sectors refer to market capitalization, and show the negative relationship between size and price impact. Note, however the effect of increasing block sizes on expected price impact, within each sector; larger trades elicit much larger price impact than do smaller trades. Looking at the evidence, the variables that determine that price impact of trading seem to be the same variables that drive the bid-ask spread. That should not be surprising.

Spierdijk, L., T. Nijman and A.H.O. Van Soest, 2002, The Price Impact of Trades in Illiquid Stocks in Periods of High and Low Market Activity, Working Paper, Tillburg University.

29 The price impact and the bid-ask spread are both a function of the liquidity of the market. The inventory costs and adverse selection problems are likely to be largest for stocks where small trades can move the market significantly. Breen, Hodrick and Korajczyk (2000) studied both the magnitude of the price impact and its determinants by looking at stocks listed on U.S. exchanges.17 They find that increasing the turnover by 0.1% in a 5minute interval can create a price impact of 2.65% for NYSE and AMEX firms and about 1.85% for NASDAQ stocks. Comparing the price impact across firms, they find evidence of the following: 1. The price impact of a trade of a given number of shares is smaller for larger market cap firms than for smaller firms. However, the price impact of a trade of the same percentage magnitude (as a percent of market cap) is greater for larger market cap firms than for smaller firms. 2. The price impact of a trade is smaller for firms with high trading volume in the previous quarter and for firms that have positive momentum (i.e, stock price has gone up in the six months prior to the trade). 3. The price impact of a trade is smaller for firms with high institutional holdings (as a percent of outstanding stock) than for a firm with lower institutional holdings. Other Assets The evidence on cross sectional differences in transactions costs is much lighter in markets other than US stocks, but there have been attempts made to quantify differences within asset classes in other markets. Bonds As we noted earlier, the US treasury security market is extremely liquid, but within that market, the most traded (and liquid) securities tend to be the most recently issued treasuries with standard maturities: the 3-month and 6-month treasury bills, the 1-5 year treasury notes and the 10-year treasury bond. Liquidity tends to drop off for seasoned treasuries with non-standard maturities, but even with the decline, the transactions costs are low. The corporate bond market is characterized by much wider

Breen, W.A., L.S. Hodrick and R.A. Korjczyk, 2000, Predicting Equity Liquidity, Working Paper, Kellogg Graduate School of Management.

30 differences in liquidity. A study that looked at all over the counter bond market trades between 2003 and 2005 concluded that highly rated bonds, recently issued bonds and bonds close to maturity are more liquid and have lower transactions costs.18 In addition, the study also found that bonds with transparent trade prices tend to be more liquid than bonds where prices are not public and visible.19 Real Estate and other real assets With real estate, you would expect illiquidity to be more of a problem in those geographical areas where there has been overbuilding and thus an imbalance between buyers and seller, and to decrease as institutional investors become a larger segment of the market. Empirically, one statistic that we referenced earlier days on market (DOM) - suggests that there are wide differences in liquidity across segments of the real estate not only by region, but also for different types of property. In November 2010, for instance, single-family homes in Fairbanks, Alaska, had spent an average of 62 days on the market whereas single-family homes in Scottsdate, Arizona, reported being on the market for 164 days, on average. At the same point in time, residential real estate has been on the market longer than commercial real estate in Fairbanks but the reverse was true in Scottsdale. The evidence from other real asset markets on liquidity is primarily anecdotal, though the opening up of online auction sites has opened provided new data for researchers. For instance, liquidity is greater for those lower-priced collectibles where a third party exists to provide a stamp of authenticity; baseball cards can be graded on quality by expert services before being put online for sale. In contrast, liquidity is a much greater concern for expensive artwork, where each piece of art has to be individually assessed and analyzed.


Edwards, A.K., L.E. Harris and M.S. Piwowar, 2007, Corporate Bond Market, Transparency and Transactions Costs, Journal of Finance, v62, 1421-1451. 19 Unlike the stock market, bond dealers provide public quotes for only a few bonds and bond transaction prices are not published. In 2002, the National Association of Security Dealers (NASD) required dealers to report all OTC bond transactions on TRACE (Trade Reporting and Compliance Engine). The study compared the liquidity of bonds whose prices were made public through this system with bonds where the prices were not reported.

31 Across time Just as liquidity can vary across assets within a market, it can vary over time for the entire market. As the banking crisis of 2008 illustrated, even the most liquid markets can become illiquid for periods of time, creating significant costs for investors who need or want to exit the market during those periods. Much of the research on time varying liquidity has come from studies on publicly traded stocks for two reasons. First, there is a long history that can be examined, especially in the United States. Second, illiquidity can be measured using observable variables such as the bid ask spread or trading volume over time. In this section, we will begin by focusing on long term trends in liquidity, primarily in equity markets, then look at short term interruptions created by crises and end with an assessment of how regulatory and tax policy can affect liquidity. Long term trends As financial markets have evolved and grown over the last century, the trend has been towards more liquidity. This increase in liquidity can be measured on many dimensions. a. Listed and traded securities: In the early part of the twentieth century, there were relatively few companies that had publicly traded, listed stock and these companies represented a small percentage of the economy. In 1926, for instance, there were about 500 companies listed on the US exchanges, whereas in 2010, there were more than 7000 listed companies in the United States, traded on several exchanges and over the counter. In emerging markets, the increase in listings has been explosive especially in the last two decades. The number of publicly listed companies in India, for instance, increased from 4344 in 1985 to 8593 in 2010. b. Investor base: When equity markets were developing in the United States, they primarily attracted money from wealthy individuals. As access to markets improved, the investor base has widened and most individuals in the US, with any savings, have some exposure to equity markets, either because of direct investments in individual stocks or holdings of mutual funds. Equity markets

32 outside the United States have also seen a similar influx of new investors and often over a much shorter time span. c. Breadth and Depth of trading: As more companies get listed and more people invest in markets, it is inevitable that trading volume will increase and it has in most markets. Not only has aggregate volume (measured in dollar value) increased over time in the US equity market, but so have turnover ratios. In summary, investors are not only trading shares in more companies, but they are also trading these shares more often than they used to. Not surprisingly, as trading volume has increased and more investors trade, transactions costs have decreased. Jones (2002), for instance, examines bid-ask spreads and transactions costs for the Dow Jones stocks from 1900 to 2000 and figure 3 presents his findings: Figure 3: Average Dollar Spread Dow Jones: 1900 - 2000

Note that the transactions costs are much lower today than they were in the early 1900s and that this may account for the lower equity risk premium in recent years.20 Within these long term trends, though, are cyclical movements, where liquidity ebbs and flows. In stock markets, volume tends to increase during long-term bull markets


This becomes clear when we look at forward-looking or implied equity risk premiums rather than historical risk premiums. The premiums during the 1990s averaged about 3%, whereas there were more than 5% prior to 1960. Jones, C.M., 2002, A Century of Stock Market Liquidity and Trading Costs, Working Paper, Columbia University.

33 and dampen during long term bear markets. It is in the real estate market that liquidity cycles are accentuated, with transactions surging in hot markets and dropping in cold markets. In conjunction, the waiting time to sell property, measured as days on the market (DOM) increases during cold markets. Figure 4 reports on the percentage of the properties in one real estate index (NCREIF) each year and the percentage change in property values from 1983 to 2003: Figure 4: Liquidity and Market Movements: Real Estate

Note the drop in transactions occurs in periods where real estate property values also drops, reflecting the fact that real estate owners often hold back properties, waiting for a better time to sell. Effects of market crises While the long-term trend in financial markets has been towards more trading and liquidity, with concurrent increases in volume and decrease in transactions costs, there have been periods of illiquidity in every market. These periods have generally coincided with market crises of one kind or the other, with the following distortions appearing in their midst: a. Order imbalances and trading halts: During crisis, sudden shifts in demand and supply can create order imbalances, with most of the orders coming in on one side of

34 the ledger. To provide an example, the S&P 500 lost more than 20% of its value on October 19, 1987. On the same day, the much riskier NASDAQ lost only 11.3%, but only because trading was halted on 195 of the 2257 stocks on the index on that day. During the last quarter of 2008, trading halts occurred frequently even on large market cap companies, as a result of demand supply imbalances. b. Increase in bid-ask spreads: When illiquidity rises during crises, bid-ask spreads change as well. The average bid-ask spread on large market cap US stocks increased substantially between September 12, 2008 and the end of that year, primarily as markets melted down and liquidity became more of an issue (see figure 5) Figure 5: Bid-ask spreads for US stocks Effects of 2008 Crisis

Note the surge in bid-ask spreads starting in September 2008 through the end of the crisis in December 2008. Concurrently, stock price volatility as measured by the Volatility Index (VIX) surged, as did the bond default spread, measured as the difference between the LIBOR and treasury bills. c. Increase in price impact: As order imbalances and bid-ask spreads increase, investors face a much bigger price impact when they trade on stocks. During the crisis of 2008, this was manifested in one of two ways. Large volume trades in either direction (buys or sells) were accompanied by large changes in prices, even for the most liquid market cap companies. In at least one company, Volkswagen, the absence of

35 illiquidity created a short squeeze in the last week of October 2008, where investors who had sold short on the stock were unable to buy shares to cover their positions, resulting in an explosive rise of 245% in the stock price of the company, making it briefly the largest market cap company in the world(see figure 6):21 Figure 6: Volkswagen Short Squeeze: October 2008

In summary, the crisis of 2008 served as a reminder that while financial markets, for the most part, are more liquid than they were several decades ago, that liquidity is more fragile than we thought it to be. While liquidity did return to markets after the crisis, there were several months during and after the crisis where investors trying to liquidate positions in equity or bond markets faced substantial trouble (and cost) in doing so. Regulatory, Legal and Tax Effects Regulatory and legal events can have significant effects on market liquidity. With US equities, for instance, we can point to two regulatory shifts that impacted transactions costs substantially. The first was the ending of fixed commissions in stock trading in 1975, which opened up the trading game, allowing new brokerage services to compete

The short squeeze was triggered by Porsche, which was a large holder of Volkswagen stock, unexpected increasing its holding of the stock (when it was expected to reduce it).

36 with established equity brokers. As a result, brokerage costs dropped dramatically in the United States. The second was in the mid-nineties, when the NASDAQ, under pressure from regulators, moved to decimalization from the old quote system (which moved in 1/16 increments) and transactions costs dropped in the aftermath. Not all regulatory and legal changes have had positive impact on liquidity. During market crises, regulatory authorities have often responded to panicked trading by putting restrictions on trading. While usually well intentioned, these restrictions often affect liquidity adversely. During the banking crisis of 2008, for instance, regulators banned short selling on a selected list of financial service companies that they believed were being targeted by speculators. Figure 7 below summarizes the effect on the bid-ask spreads of these companies and contrasts that with the bid-ask spreads of companies that were not covered by the short sales ban. Figure 7: Short Sales Bans and Bid Ask Spreads

Note that the bid-ask spreads of companies, with short sales bans, increased much more during the crisis than the bid-ask spreads of companies not subject to the ban. Tax policy can also affect liquidity. A tax imposed on financial transactions, for instance, will reduce trading and can be viewed as an added transactions cost. Umlauf (1993) examined the impact of an increase in the transactions tax rate from 1% to 2% in Sweden in 1986 and found a drop in trading volume of 30% in the market in the

37 aftermath, as trading migrated to other markets.22 If the tax rate paid on investment profits is a function of holding period, it can affect whether and how much investors transact. The presence of a capital gains tax rate, where price appreciation gets taxed when an asset is sold for a price higher than it originally cost, but only if it is held for more than 6 months, will lead to investors to defer sales of their best-performing investments. The cost of illiquidity As the last section makes clear, liquidity, measured in term of volume and transactions costs, can vary across markets, across assets within each market and across time. But how much do investors care about this liquidity? In this section, we will not only present evidence that investors do factor liquidity into pricing decisions, but we will also argue that the cost of illiquidity will vary across time. Across assets within an asset class One approach to evaluating how much investors care about illiquidity is to look at how they price assets within the same market, given the differences in liquidity. In the sections below, we will first review the evidence from the bond market and then look at the much richer data in the stock market. Bonds Liquidity can vary across bonds issued by different entities, and across maturities, for bonds issued by the same entity. These differences in liquidity offer us an opportunity to examine whether investors price liquidity and if so, how much, by comparing the yields of liquid bonds with otherwise similar illiquid bonds. Studies of bond market liquidity have looked at the treasury bond, corporate bond and subordinated bond markets. Treasury Bills/Bonds: Amihud and Mendelson (1991) compared the yields on treasury bonds with less than six months left to maturity with treasury bills that have the same maturity.23 They concluded that the yield on the less liquid treasury bond

Umlauf, Steven R., 1993, Transaction taxes and the behavior of the Swedish stock market, Journal of Financial Economics 33, 227-240. 23 Amihud, Y., and H. Mendelson, 1991, Liquidity, Maturity and the Yield on U.S. Treasury Securities,

38 was 0.43% higher on an annualized basis than the yield on the more liquid treasury bill, a difference that they attributed to illiquidity. A subsequent study by Kamara (1994) confirmed their finding and concluded that the yield difference was 0.37%.24 Strebulaev (2002) contests their finding, noting that the tax treatment on bonds varies from the tax treatment of treasury bills and that this may explain the difference in yields. He compares treasury notes maturing on the same date and concludes that they trade at essentially identical prices, notwithstanding big differences in liquidity.25 Corporate bonds: Chen, Lesmond and Wei (2005) compared over 4000 corporate bonds in both investment grade and speculative categories, and concluded that illiquid bonds had much higher yield spreads than liquid bonds. To measure liquidity, they used multiple measures including the bid-ask spread, the occurrence of zero returns in the time series26 and the LOT measure (which incorporates the bid-ask spread, opportunity costs and price impact). Not surprisingly, they find that liquidity decreases as they move from higher bond ratings to lower ones and increases as they move from short to long maturities. Comparing yields on these corporate bonds, they conclude that the yield increases 0.21% for every 1% increase in transactions costs for investment grade bonds, whereas the yield increases 0.82% for every 1% increase in transactions costs for speculative bonds.27 Subordinated bonds: A study of 211 subordinated bonds issued by 22 large banks in the United States concluded that more illiquid bonds trade at higher default spreads than otherwise similar liquid bonds.28 They find that bonds that have not traded within the last six months have a default spread that is about 0.20% higher than traded

Journal of Finance, 46, 1411-1425. 24 Kamara, A., 1994, Liquidity, Taxes, and Short-Term Yields, Journal of Financial and Quantitative Analysis, 29, 403-417. 25 Strebulaev, I., 2002, Liquidity and Asset Pricing: Evidence from the US Treasuries Market, Working Paper, London Business School. 26 When an asset does not trade during a period, the return will be zero during the period. Counting the number of zero return periods can provide one proxy for illiquidity. 27 Chen, L., D.A. Lesmond and J. Wei, 2005, Corporate Yield Spreads and Bond Liquidity, Working Paper, SSRN. 28 Bianchi, C., D. Hancock and L. Kawano, 2004, Does Trading Frequency affect Subordinated Debt Spreads? Working Paper, Federal Reserve Bank, Washington D.C. To measure liquidity, they consider whether a generic price is available on Bloomberg for a bond. Since a generic price is available only when a bond trades, it becomes a proxy for liquidity with more liquid bonds having more generic prices listed for them.

39 bonds , and that this spread widens out to 0.64% when the bond has not traded in the last two years. Looking across the studies, the consensus finding is that liquidity matters for all bonds, but that it matters more with risky bonds than with safer bonds. This may explain why the prevalence of a liquidity premium in the government bond market is debatable but not in the corporate bond market. Stocks Studies of illiquidity in the equity market have run the gamut ranging from those examining differences in liquidity across stocks and how these differences translate into differences in expected returns, to more focused studies, that try to find a subset of stocks where illiquidity is an issue and then measure how investors react to that illiquidity. Differences across stocks Some stocks are more liquid than others and the consensus conclusion is that investors demand higher returns when investing in more illiquid stocks. Put another way, investors are willing to pay higher prices for more liquid investments relative to less liquid investments. The first set of evidence that liquidity matters and is priced in by investors is largely circumstantial. While it would be foolhardy to attribute all of the well documented excess returns29 that have been associated with owning small market capitalization and low price to book stocks to illiquidity, smaller and more distressed companies (which tend to trade at low price to book ratios) to liquidity differences, it cannot be coincidence that these are among the most illiquid companies in the market. The interplay between illiquidity and so many observed inefficiencies in the market suggests that it plays a key role in how investors price stocks and the returns that we observe in the aftermath. It may also explain why there are so many ways of making excess returns on paper and so few in practice. The other strand of research links liquidity more directly to returns, by using measures of liquidity to explained differences in stock returns over long time periods. Amihud and Mendelson (1989) examined whether adding bid-ask spreads to betas helped

Fama, E.F. and K.R. French, 1992, The Cross-Section of Expected Returns, Journal of Finance, v47, 427-466.

40 better explain differences in returns across stocks in the U.S.30 In their sample of NYSE stocks from 1961-1980, they concluded that every 1% increase in the bid-ask spread (as a percent of the stock price) increased the annual expected return by 0.24-0.26%. Eleswarapu (1997) confirmed this finding by showing a positive relationship between returns and spreads for Nasdaq stocks.31 Other studies have used trading volume, turnover ratios (dollar trading volume/ market value of equity) and illiquidity ratios as proxies for illiquidity with consistent results. Brennan and Subrahmanyan(1996) break transactions costs down into fixed and variable costs and find evidence of a significant effect on returns due to the variable cost of trading after controlling for factors such as firm size and the market to book ratio.32 Brennan, Chordia and Subrahmanyam (1998) find that dollar trading volume and stock returns are negatively correlated, after adjusting for other sources of market risk.33 Datar, Nair and Radcliffe (1998) use the turnover ratio as a proxy for liquidity. After controlling for size and the market to book ratio, they conclude that liquidity plays a significant role in explaining differences in returns, with more illiquid stocks (in the 90the percentile of the turnover ratio) having annual returns that are about 3.25% higher than liquid stocks (in the 10th percentile of the turnover ratio). In addition, they conclude that every 1% increase in the turnover ratio reduces annual returns by approximately 0.54%.34 Amihud (2002) developed a measure of illiquidity by dividing the absolute price change by the average daily trading volume for the stock to estimate an illiquidity ratio and concluded that stock returns are positively correlated with this measure.35 Nguyen, Mishra and Prakash (2005) conclude that stocks with higher


Amihud, Y. and . Mendelson, 1989, the Effects of Beta, Bid-Ask Spread, Residual Risk and Size on Stock Returns, Journal of Finance, v 44, 479-486. 31 Eleswarapu, V.R. 1997, Cost of transacting and expected returns in the Nasdaq Market, Journal of Finance, 52 (5), 2113-2127. There are other studies that find a weaker or no relationship between stock returns and bid-ask spreads. Chalmers and Kadec use the amortized spread and find no relationship between spreads and returns for NYSE stocks. Chalmers, J.M.R. and G.B. Kadlec, 1998, An Empirical examination of the Amortized Spread, Journal of Financial Economics, 48 (2), 159-188. 32 Brennan, M. J. and A. Subrahmayam, 1996, Market microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns, Journal of Financial Economics 41, 441-464. 33 Brennan, M. J., T. Chordia, and A. Subrahmanyam, 1998. Alternative factor specifications,security characteristics and the cross-section of expected stock returns, Journal of Financial Economics, 49, 345 373. 34 Datar, V.T., N. Y. Naik and R. Radcliffe, 1998, Liquidity and stock returns: An alternative test, Journal of Financial Markets 1, 203-219. 35 Amihud, Y., 2002, Illiquidity and stock returns: Cross-section and time-series effects, Journal of Financial Markets 5, 31-56.

41 turnover ratios do have lower expected returns. They also find that market capitalization and price to book ratios, two widely used proxies that have been shown to explain differences in stock returns, do not proxy for illiquidity.36 There are a few studies that focus on subsets of the market to examine the effects of liquidity and pricing and arrive at the same conclusions: liquidity matters and investors price them in. For instance, Ellul and Pagano (2002) related the underpricing of 337 British initial public offerings to the illiquidity of the issues after the offerings, and found evidence that the less liquid shares are expected to be and the less predictable the liquidity, the greater the under pricing.37 Differences across Control Groups Studies that compare stocks with different liquidity can always be faulted for not controlling for other factors. After all, companies with more liquid stocks tend to have larger market capitalization and lower risk. Consequently, the cleanest tests for illiquidity are those that compare stocks with different degrees of liquidity issued by the same company. Differences in stock prices can then be attributed purely to liquidity. a. Restricted stock: Much of the evidence on illiquidity discounts comes from examining restricted stock issued by publicly traded firms. Restricted securities are securities issued by a publicly traded company, not registered with the SEC, and sold through private placements to investors under SEC Rule 144. They cannot be resold in the open market for a one-year holding period38, and limited amounts can be sold after that. When this stock is issued, the issue price is set much lower than the prevailing market price, which is observable, and the difference can be viewed as a discount for illiquidity. The results of two of the earliest and most quoted studies that have looked at the magnitude of this discount are summarized below:


Ngyuen, D., S. Mishra and A.J. Prakash, 2005, On Compensation for Illiquidity in Asset Pricing: An Empirical Evaluation using the Three-factor Model and the Three-moment CAPM, Working Paper, SSRN. 37 Ellul, A. and M. Pagano, 2002, IPO Underpricing and After-market Liquidity, Working Paper, SSRN. 38 The holding period was two years prior to 1997 and has been reduced to one year since.

42 Maher examined restricted stock purchases made by four mutual funds in the period 1969-73 and concluded that they traded an average discount of 35.43% on publicly traded stock in the same companies.39 Silber examined restricted stock issues from 1981 to 1988 and found that the median discount for restricted stock is 33.75%.40 He also noted that the discount was larger for smaller and less healthy firm, and for bigger blocks of shares. Other studies confirm these findings of a substantial discount, with discounts ranging from 30-35%. One more recent study by Johnson (1999) did find a smaller discount of 20%.41 These discounts suggest a large cost to illiquidity, but there are reasons to be skeptical. First, these studies are based upon small sample sizes, spread out over long time periods, and the standard errors in the estimates are substantial. Second, most firms do not make restricted stock issues and the firms that do make these issues tend to be smaller, riskier and less healthy than the typical firm. This selection bias may be skewing the observed discount. Third, the investors with whom equity is privately placed may be providing other services to the firm, for which the discount is compensation. One way of isolating the service difference would be to compare unregistered private placements, which represent the restricted stock issues, to registered private placements of equity by companies. Since only the former have restrictions on marketability, the difference in discounts between the two may be a better measure of the illiquidity discount. Wruck (1989) made this comparison and estimated a difference of 17.6% in average discounts and only 10.4% in the median discount between the two types of placements.42 Hertzel and Smith (1993) expanded on this comparison of restricted stock and registered private placements by looking at 106 private placements of equity from 1980 to 1987.43 They concluded that while the median discount across all private placements was 13.26%, the

Maher, J.M., 1976, Discounts for Lack of Marketability for Closely Held Business Interests, Taxes, 54, 562-571. 40 Silber, W.L., 1991, Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices, Financial Analysts Journal, v47, 60-64. 41 B. A. Johnson,1999, Quantitative Support for Discounts for Lack of Marketability, Business Valuation Review, v16, 152-55 . 42 Wruck, K.H., 1989, Equity Ownership Concentration and Firm Value: Evidence from Private Equity Financings, Journal of Financial Economics, 23. 3-28. She concluded that a significant portion of the discount could be attributed to control changes at the firms. 43 Hertzel, M. and R.L. Smith, 1993, Market Discounts and Shareholder Gains from Placing Equity Privately, Journal of Finance, v48, 459-486.

43 discount was 13.5% higher for restricted stock than for registered stock. Bajaj, Dennis, Ferris and Sarin (2001) looked at 88 private placements from 1990 to 1997 and report median discounts of 9.85% for registered private placements and 28.13% for restricted stocks. After controlling for differences across the firms making these issues, they attribute only 7.23% to the illiquidity discount.44 b. Companies with multiple share classes: Some companies have multiple classes of shares traded, with some classes being more liquid than others. If there are no other differences (in voting rights or dividends, for instance) across the classes, the difference in prices can be attributed to liquidity. In the Chinese market, for instance, most companies have Restricted Institutional Shares (RIS) which are illiquid45 and common shares which are traded on the exchange. Chen and Xiong (2001) compare the market prices of the traded common stock in 258 Chinese companies with the auction and private placement prices of the RIS shares and conclude that the discount on the latter is 78% for auctions and almost 86% for private placements.46 This astoundingly high discount, which they attributed to illiquidity, does vary across firms, with smaller discounts at larger, less volatile firms. In a different vein, researchers have compared the stock prices of Class A and Class B shares of Chinese companies. The former are open only to Chinese investors, whereas the latter can be bought by both domestic and foreign investors. While they both offer the same claims on the cashflows, Class B shares trade at a significant discount on Class A shares. The differences, though, seem to be only partially attributable to differences in liquidity and seem more due to differential information.47


Bajaj, M., D.J. Dennis, S.P.Ferris and A.Sarin, 2001, Firm Value and Marketability Discounts, Journal of Corporate Law, v27. 45 Restricted Institutional Shares have to be transacted through private placements. Starting in August 2000, the Chinese Government has also allowed for auctions of these shares, where it is presumably a little easier to find a potential buyer. 46 Chen, Z. and P. Xiong, 2001, Discounts on Illiquid Stocks: Evidence from China, Working Paper, Yale University. 47 Wang, S.S. and L. Jiang, 2003, Location of Trade, Ownership Restrictions, and Market Illiquidity: Examining Chinese A- and H-Shares, Working Paper, Hong Kong Polytechnic University. Chan, K., A.J. Menkveld and Z. Yang, 2002, Evidence of the Foreign Share Discount Puzzle in China: Liquidity or Information Asymmetry, Working Paper, National Center for Economic Research, Tsinghua University.

44 Across time When market liquidity increases, you should expect to see an increase in asset prices accompanied by a drop in the return you would require that asset to make; the difference between this expected return and the risk free rate is the risk premium for that asset class. In the equity market, some of the risk premium attributed to equity can be attributed to liquidity costs. In the last section, we referenced a study by Jones that looks at transactions costs on the Dow 30 stocks over time and notes a decline in the cost. That study also presents evidence that increases in the bid-ask spread and lower turnover are harbingers of higher stock returns in the future, which he takes as evidence that illiquidity is a factor behind both the magnitude of and changes in the equity risk premiums. His research is in line with others who have argued that variations in liquidity (and the associated costs) over time may explain a portion of the shifts in the equity risk premium from period to period. In the bond market, as investors become more concerned about illiquidity, they will demand higher interest rates and default spreads. In figure 8, we graph the implied equity risk premium for the US market, extracted from the index level and expected cash flows, and the default spread on a Baa bond from 1960 to 2010.

45 Both the equity risk premium and the Baa default spread vary over time, though the variation can be attributed to a multitude of factors: changing risk aversion, uncertainty about the economy, fear of catastrophe and illiquidity. Some of the variation can be attributed to illiquidity and it intuitively makes sense that investors care more about liquidity (or its absence) in some periods than others, and charge a higher price for it. Across investors While all investors care about liquidity, not all of them care about it to the same extent. There are at least four factors that come into play in determining the cost attached to illiquidity: Time horizon: Investors with shorter time horizons will be more negatively affected by illiquidity than investors with longer time horizons, for the simple reason that they are more exposed to that cost. If you turn your portfolio over twice a year, you will incur much more in transactions costs than if you turn your portfolio ten times a year. Investment philosophy: Momentum investors who trade on information will face larger costs from illiquidity than contrarian investors trading on value. Type of assets held: As liquidity changes at the market wide level, the effects are likely to be much greater for assets that were relatively illiquid to begin with. Thus, a fund that invests in small companies or privately owned businesses is likely to face a much larger cost from increased illiquidity than one that invests in large market cap companies. Financial leverage: Investment strategies that are more dependent upon borrowing money will be more exposed to illiquidity costs, because it will represent a higher percentage of the value of equity in the portfolio. A 5% impact on the price of an asset, funded with 80% debt, translates into a 25% loss in equity value. During the banking crisis of 2008, there were hedge funds that were forced into liquidation or pushed to the precipice by illiquidity in the market. Many of these funds invested in lightly traded assets, where the illiquidity costs were highest, had impatient or nervous investors who wanted to cash out and used debt liberally. In fact, illiquidity create a vicious feedback loop at these funds, where poor returns on investments

46 precipitate cash withdrawals by fund investors, which triggers more asset sales at discounts, which triggers worse returns, which trigger more withdrawals and so on. If the cost of illiquidity varies across investors, it follows that there should be a potential for profit on the part of those investors whose liquidity profiles dont match the norm. Put in less abstract terms, a long term value investor, who cares little about liquidity, will be a buyer during a liquidity crisis. This liquidity arbitrage will be most profitable when markets become less liquid and the cost of illiquidity rises, since investors who care about illiquidity will mark prices down to levels that make them attractive to investors who do not. To provide an example, during the market crisis of 2008, Warren Buffett made well-publicized investments in Goldman Sachs and GE, when these big-name firms were confronted with illiquidity problems. While those investments were not riskless the market could have melted down- they have paid off handsomely as liquidity has returned to markets and health to the companies. Privately held assets If investors attach a cost to illiquidity at publicly traded investments, in crisis periods, it stands to reason that they will charge an even higher cost for investments that are not publicly traded. In most cases, though, it is difficult to quantify this cost because the observed transactions price already reflects the illiquidity discount. In this section, we will look at private equity, real estate and private business appraisals for clues on how much investors value liquidity. Private Equity Private equity and venture capital investors often provide capital to private businesses in exchange for a share of the ownership in these businesses. Implicit in these transactions must be the recognition that these investments are not liquid. If private equity investors value liquidity, they will discount the value of the private business for this illiquidity and demand a larger share of the ownership of illiquid businesses for the same investment. Looking at the returns earned by private equity investors, relative to the returns earned by those investing in publicly traded companies, should provide a measure of how much value they attach to illiquidity.

47 Ljungquist and Richardson (2003) estimate that private equity investors earn excess returns of 5 to 8%, relative to the public equity market, and that this generates about 24% in risk-adjusted additional value to a private equity investor over 10 years. They interpret it to represent compensation for holding an illiquid investment for 10 years.48 Das, Jagannathan and Sarin (2003) take a more direct approach to estimating private company discounts by looking at how venture capitalists value businesses (and the returns they earn) at different stages of the life cycle. They conclude that the private company discount is only 11% for late stage investments but can be as high as 80% for early stage businesses.49 Franzoni, Nowak and Phalippou (2009) look at 3421 liquidated private equity investments between 1981 and 2000 and conclude that investors in private equity funds price in this liquidation risk by demanding premiums of up to 15% for investing in these funds.50 However, there are perils in concluding that these discounts are for marketability. In addition to illiquidity, private equity investors often are not diversified and some of the additional return may represent a premium for this nondiversification. In addition, private equity investors also exercise some or even significant control over the firms they invest in, and the higher payoff may reflect the value of this control. Privately owned businesses While it may be difficult to back out illiquidity discounts from transactions prices for private businesses, there are indications that investors demand and get large illiquidity discounts at these businesses. Here is some evidence: a. Appraisal practices: The standard practice in many private company valuations is to either use a fixed illiquidity discount for all firms or, at best, to have a range for the discount, with the analysts subjective judgment determining where in the range a particular companys discount should fall. The genesis for these fixed discounts seems to be in the studies of restricted stock that we noted in the last section. These


Ljungquist, A. and M. Richardson, 2003, The Cashflow, Return and Risk Characteristics of Private Equity, Working Paper, Stern School of Business. 49 Das, S., M. Jagannathan and A. Sarin, 2002, The Private Equity Discount: An Empirical Examination of the Exit of Venture Capital Companies, Working Paper, SSRN. 50 Franzoni, F., E. Nowak and L. Phallippou, 2009, Private Equity and Liquidity Risk, Working Paper, University of Lugano.

48 studies found that restricted (and therefore illiquid) stocks traded at discounts of 2535%, relative to their unrestricted counterparts, and private company appraisers have used discounts of the same magnitude in their valuations.51 Since many of these valuations are for tax court, we can see the trail of restricted stock based discounts littering the footnotes of dozens of cases in the last three decades.52 b. Comparison of private to public transactions prices: One way to measure the illiquidity discount attached to private companies is to compare the prices at which private businesses are sold relative to the prices at which publicly traded companies trade at. Koeplin, Sarin and Shapiro (2000) provide an illustration of this approach by comparing the multiples paid for 84 private companies that were acquisition targets to the multiples of earnings paid for 198 similar publicly traded firms between 1984 and 1998.53 Figure 9 shows the average multiples of earnings, book value and sales for private and public firms:


In recent years, some appraisers have shifted to using the discounts on stocks in IPOs in the years prior to the offering. The discount is similar in magnitude to the restricted stock discount. 52 As an example, in one widely cited tax court case (McCord versus Commissioner, 2003), the expert for the taxpayer used a discount of 35% that he backed up with four restricted stock studies. 53 The multiples they used were all based upon enterprise value (market value of equity + debt cash) in the numerator. They compared enterprise value to EBIT, EBITDA, Sales and the Book Value of Capital. Koeplin, J., A. Sarin and A. Shapiro, 2000, The Private Company Discount, Journal of Applied Corporate Finance, v12.


Figure 9: Private versus Public Acquisitions

EV/Book Value




0 Publicly traded companies Private companies

4 EV/EBIT 16.39 11.76

8 EV/EBITDA 10.15 8.08


12 2.86 2.35


16 1.32 1.35



EV/Book Value

Private companies

Publicly traded companies

Note that, with the exception of revenue multiples, the private companies were acquired at multiples about 20-30% lower than those paid for publicly traded firms; the discount was larger (40-50%) for foreign private firms. The authors do note that notwithstanding their attempts to get a controlled sample, the private companies in their sample were smaller and had higher growth rates than the publicly traded companies.

Consequences of Illiquidity
If markets are illiquid, we have to adapt both portfolio theory and corporate finance to reflect this reality. In this section, we will examine how high transactions costs and the inability to trade can alter the way in which we approach valuation, asset allocation, security selection and corporate financial decisions. Asset Pricing and Valuation In an earlier section, we noted how both discounted cash flow valuation and relative valuation pays scant attention to illiquidity. If illiquidity is a significant problem, it behooves us to incorporate its effects more systematically into valuations.

50 Intrinsic Valuation The notion that investors will pay less for illiquid assets than for otherwise similar liquid assets is neither new nor revolutionary. Over the last two decades researchers have considered two ways of incorporating the effect of illiquidity into value. In the first, the value of an asset is reduced by the present value of expected future transactions costs, thus creating a discount on value. In the second, the required rate of return (discount rate) on an asset is adjusted to reflect its illiquidity, with higher required rates of return (and lower values) for less liquid assets. One solution: A post-valuation discount While most analysts accept the proposition that illiquid assets should be valued lower than otherwise similar, more liquid assets, they are reluctant to incorporate the illiquidity effects into valuation inputs: cash flows and discount rates. Instead, they adopt standard valuation models that ignore illiquidity to value assets and discount that value at the last stage for illiquidity. The theory Assume that you are an investor trying to determine how much you should pay for an asset. In making this determination, you have to consider the cashflows that the asset will generate for you and how risky these cashflows are to arrive at an estimate of intrinsic value. You will also have to consider how much it will cost you to sell this asset when you decide to divest it in the future. In fact, if the investor buying it from you builds in a similar estimate of transactions cost she will face when she sells it, the value of the asset today should reflect the expected value of all future transactions costs to all future holders of the asset. This is the argument that Amihud and Mendelson used in 1986, when they suggested that the price of an asset would embed the present value of the costs associated with expected transactions costs in the future.54 In their model, the bid-ask spread is used as the measure of transactions costs and small spreads can translate into big illiquidity discounts on value. The magnitude of the discount will be a function of investor holding periods and turnover ratios, with shorter holding periods and higher turnover associated with bigger discounts. Vayanos (1998) argues that the effect of

Amihud, Y. and H. Mendelson, 1986, Asset Pricing and the Bid-ask Spread, Journal of Financial Economics, v 17, 223-250.

51 changes in transactions costs on asset prices is much smaller than estimated by Amihud and Mendelson because investors adjust holding periods to reflect transactions costs. In fact, he argues that the price of a stock can actually increase as its transactions costs increase, especially for more frequently traded stocks; the increase in holding periods can offset the transactions costs increase.55 Jarrow and Subramanian (2001) present an alternate model for estimating the illiquidity discount on value.56 They model the discount as the difference between the market value of an asset and its value when liquidated and argue that the discount should be larger when there are execution lags in liquidation. They derive optimal trading rules and the magnitude of the illiquidity discount for investors with power utility functions. Lo, Mamaysky and Wang (2001) assume fixed transactions costs and conclude, like Amihud and Mendelson, that small trading costs can create significant illiquidity discounts and that these discounts are influenced heavily by the risk aversion of investors.57 In summary, the studies that develop theoretical models for illiquidity discounts all link them to expected transactions costs on assets but require investor holding periods as an input for estimating the magnitude of the discount. The discount for any given transaction costs will be smaller if investors have long time horizons than if they have short time horizons. In practice In conventional valuation, the cashflows are expected cashflows, the discount rate is usually reflective of the risk in the cashflows and the present value we obtain is the value for a liquid business. As we noted earlier, appraisers of private businesses are explicit about discounting their estimated values for illiquidity, often applying discounts of 20% or higher to arrive at their final estimate. However, analysts valuing publicly traded companies make no such adjustment, thus implicitly assuming that illiquidity is not a large enough concern to affect value. Much of the theoretical and empirical


Vayanos, D., 1998, Transactions Costs and Asset Prices: A Dynamic Equilibrium Model, Journal of Financial Economics, v11, 1-58. 56 Jarrow, R. and A. Subramanian, 2001, The Liquidity Discount, Mathematical Finance, v11, 447-474. 57 Lo, A.W., H. Mamaysky and J. Wang, 2001, Asset Prices and Trading Volume under Fixed Transactions Costs, Working Paper, Yale International Center of Finance.

52 discussion in this paper supports the view that illiquidity is a problem even for publicly traded stock, and is more of a problem for some stocks than for others. If we accept the proposition that the value of a publicly traded stock has to be adjusted for illiquidity, we are then faced with a secondary question. How can we estimate the illiquidity discount? We can adopt the private appraiser practice of discounting the estimated value of more illiquid stocks, using the studies of restricted stock and IPOs to back up the estimated discounts. However, there is a better way. A publicly traded stock has a bid-ask spread that provides a direct measure of illiquidity in that stock, and that spread can be employed to estimate the appropriate discount to estimated value. In fact, adapting the Amihud-Mendelson construct from the last section, the illiquidity discount can be written as follows: Illiquidity Discount =
!"# !"#$%!!"# !"#$% (!"# !"#$%!!"# !"#$%)

!"#$%&$' !!"#$%& !"#$%& !" !"#$%

!"#$ !" !"#$%&

Intuitively, we are estimating the annualized cost of trading over the time horizon of the investment in the numerator and then computing the present value of this cost in perpetuity. Thus, the illiquidity discount for a stock with a cost of equity of 10%, a bid price of $ 1.80, an ask price of $ 2.00, to an investor with a four-year holding period will be as follows:58 Illiquidity Discount =
!.!"!!.!" (!.!"!!.!")


= .125 or 12.5%

While the approach is simple, it illustrates the factors that should cause illiquidity discounts to vary across companies, investors and time: Across assets: Securities with higher bid-ask spreads, as a percent of the stock price, should have higher illiquidity discounts than stocks that have lower bid-ask spreads. Thus, all of the factors that determine the spread indirectly determine the liquidity discount; thus, lightly traded stocks, low priced stocks and small market cap companies should have larger illiquidity discounts. Across investors: Note that the illiquidity discount will vary across potential buyers, depending upon their liquidity preference (captured in the holding period). It is likely that those buyers who have deep pockets, longer time horizons and see

The spread between the bid and the ask price is the cost of a total round trip transaction. Thus, it captures the cost of buying and later selling the same security.

53 little or no need to cash out their equity positions will attach much lower illiquidity discounts to value, for similar firms, than buyers that do not possess these characteristics. Across time: The illiquidity discount is also likely to vary across time, as the market-wide desire for liquidity ebbs and flows and bid-ask spreads shift. In other words, the illiquidity discount attached to the same business will change over time even for the same buyer. Table 2 estimates the illiquidity discount as a function of the bid-ask spread (as a percent of the stock price) and the time horizon of the investor, assuming a cost of equity of 10%: Table 2: Illiquidity Discount to Value: Capitalized Bid-ask spreads Spread as % of price 1% 2% 3% 4% 5% 1 year 5.00% 10.00% 15.00% 20.00% 25.00% Time Horizon of investor 2 years 5 years 2.50% 1.00% 5.00% 2.00% 7.50% 3.00% 10.00% 4.00% 12.50% 5.00% 10 years 0.50% 1.00% 1.50% 2.00% 2.50%

This approach does yield very high discounts for short-term investors in securities with high bid-ask spreads. An alternative: Adjust the discount rate If illiquidity is a risk associated with an investment, it seems logical that we should be using higher discount rates for cash flows on an illiquid investment than for cash flows on a liquid investment. The question then becomes one of measuring illiquidity and translating that measure into a discount rate effect. The Theory In conventional asset pricing models, the required rate of return for an asset is a function of its exposure to market risk. Thus, in the CAPM, the cost of equity is a function of the beta of an asset, whereas in the APM or multi-factor model, the cost of equity is determined by the assets exposure to multiple sources of market risk. There is little in these models that allow for illiquidity. Consequently, the required rate of return will be the same for liquid and illiquid assets with similar market risk exposure. In recent years, there have been attempts to expand these models to allow for illiquidity risk in one

54 of two ways. The first are theoretical models that build in a market premium for illiquidity that affects all assets and measures of illiquidity for individual assets. Differences in the latter will cause required rates of return to vary across companies with different degrees of liquidity. The second are purely empirical multi-factor models that attempt to explain differences in returns across stocks over long time periods, with a measure of illiquidity such as trading volume or the bid-ask spread considered one of the factors. The earliest theoretical discussions of how best to incorporate illiquidity into asset pricing models occurred in the 1970s. Mayers (1972, 1973, 1976) extended the capital asset pricing model to consider non-traded assets as well as human capital.59 The resulting models did not make explicit adjustments for illiquidity, though. In a more recent attempt to incorporate illiquidity into expected return models, Acharya and Pedersen (2005) examine how assets are priced with liquidity risk and make a critical point.60 It is not just how illiquid an asset is, but also when it is illiquid. In particular, an asset that is illiquid when the market itself is illiquid (which usually coincides with down markets and economic recessions) should be viewed much more negatively (with a resulting higher expected return) than an asset that is illiquid when the market is liquid. Thus the liquidity beta of an asset will reflect the covariance of the assets liquidity with market liquidity. The empirical models take a simpler route to adjusting discount rates. Rather than compute liquidity betas, they draw on the studies that we quoted in an earlier section, relating expected returns on stocks to measures of liquidity (bid-ask spreads, turnover ratios, trading volume). They incorporate one of these measures into their expected return models as a proxy for liquidity and compute the expected return. Thus, the CAPM can be modified:


Mayers, D., 1972, Nonmarketable assets and capital market equilibrium under uncertainty, in M.C. Jensen, Studies in the Theory of Capital Markets (Praeger, New York, NY); Mayers, D., 1973, Nonmarketable assets and the determination of capital asset prices in the absence of a riskless asset, Journal of Business, v46, 258-267; Mayers, D., 1976, Nonmarketable assets, market segmentation and the level of asset prices, Journal of Financial and Quantitative Analysis, v11, 1-12. 60 Acharya, V. and L.H. Pedersen, 2005, Asset Pricing with Liquidity Risk, Journal of Financial Economics, v77, 375-410.

55 Expected Return = Riskfree Rate + Beta * Equity Risk Premium + Liquidity Proxy * Premium per liquidity unit In summary, both the theoretical models and the empirical results suggest that we should adjust discount rates for illiquidity, with the former focusing on systematic liquidity as the key factor and the latter using proxies such as bid-ask spreads and turnover ratios to measure liquidity. Both approaches also seem to indicate that the adjustment will vary across time and will be dependent upon a market wide demand for liquidity. Thus, for any given level of illiquidity, the expected premium added on to discount rates will be much greater in periods when the market values liquidity more and smaller in periods when it values it less. In practice To adjust the discount rate used in discounted cashflow valuation for illiquidity, you have to add an illiquidity premium to the discount rate and derive a lower value for the same set of expected cashflows. The asset pricing models that attempt to incorporate illiquidity risk are not specific about how we should go about estimating the additional premium (other than saying that it should be larger for investments which are illiquid when the market is illiquid). There are two practical solutions to the estimation problem: 1. Add a constant illiquidity premium to the discount rate for all illlquid assets to reflect the higher returns earned historically by less liquid (but still traded) investments, relative to the rest of the market. This is akin to another very common adjustment made to discount rates in practice, which is the small stock premium. The costs of equity for smaller companies are often augmented by 3-3.5% reflecting the excess returns earned by smaller cap companies over very long periods. The same historical data that we rely on for the small stock premium can provide us with an estimate of an illiquidity premium. Practitioners attribute all or a significant portion of the small stock premium reported by Ibbotson Associates to illiquidity and add it on as an illiquidity premium. An alternative estimate of the premium emerges from studies that look at venture capital returns over long period. Using data from 1984-2004, Venture Economics, estimated that the returns to venture capital investors have been about 4% higher

56 than the returns on traded stocks.61 We could attribute this difference to illiquidity and add it on as the illiquidity premium for all private companies. If discount rates are adjusted for illiquidity, the key is to avoid double counting and not discount the estimated value again for illiquidity.62 The peril of this approach is that it treats illiquidity as an either/or variable rather than a continuum. In other words, an asset is either liquid (in which case the estimated value is unchanged) or illiquid (in which case the discount rate is adjusted upwards). As we have noted through this paper, all assets are illiquid with the only question being one of degree. 2. Add a firm-specific illiquidity premium, reflecting the illiquidity of the asset being valued: For liquidity premiums that vary across companies, we have to estimate a measure of how exposed companies are to liquidity risk. Here, we have two choices: a. Liquidity Beta approach: One alternative is to estimate liquidity betas or their equivalent for individual companies. To get the cost of equity, we need three other market inputs the riskfree rate, the equity risk premium and liquidity premium for the market and one other company specific input the market beta for the company. The final estimate of cost of equity is: Cost of equity = Riskfree Rate + Beta * ERP + Liquidity Beta * Liquidity Risk Premium The two new inputs needed to put this model to use are the liquidity beta and a liquidity risk premium. Drawing on the work done on the liquidity based capital asset pricing model, these liquidity betas should reflect not only the magnitude of trading volume on an investment, but how that trading volume varies with the market trading volume over time. In practice, you would run a regression akin to the market regression used to estimate conventional betas, but using changes in the stocks trading volume (rather than price) as your dependent variable and changes in the markets trading volume (rather than index levels) as your independent variable. To illustrate, the volume regressions were run for two companies: Disney, a widely held and traded stocks in the market, and Playboy

The sample of several hundred venture capital funds earned an annual average return of 15.7% over the period whereas the annual average return was 11.7% on the S&P 500 over the same period. They did not adjust for risk. Broken down into classes, venture capital investments in early stage companies earned 19.9% whereas investments in late stage ventures earned only 13.7%. 62 This is a common occurrence in private company valuations. Appraisers often use the build-up approach to estimate discount rates, adding small cap and other premiums to arrive at high rates. They discount cash flows at these rates to arrive at an estimated value, which they then reduce again with 20-25% illiquidity discounts.

57 Enterprises, a smaller market cap stock, with less liquidity, using monthly trading volume from 2004-2010 (see figure 10): Figure 10: Trading Volume Scatter Plots January 2004 to November 2010 Disney vs S&P 500
1.5 1 0.5 0 -0.5 0 SPX: % 0.5 PlayboyL: % Disney: % 1.5 1 0.5 0 -0.5 0 SPX: % 0.5

Playboy vs S&P 500



VolumeDisney = 0.03 + 0.71 VolumeSPX

VolumePlayboy = 0.50 + 1.40 VolumeSPX for Playboy

Note that the illiquidity beta for Disney is 0.71, whereas it is 1.40 Playboy is twice as exposed to liquidity variations in the market than Disney.

Enterprises. If these estimates are correct (and there is significant standard error in each), The liquidity risk premium is a trickier number to estimate. One solution is to use the historical small cap or venture capital premium that we noted in the last section as the liquidity risk premium. That would give use values of about 3-4% for the liquidity premiu, based upon US data from 1928-2010. The second is to estimate an implied equity risk premium for an index of all stocks and compare that premium to the implied equity risk premium for the most liquid stocks in the market. The advantage of this approach is that it is forward looking and dynamic; it will rise during crises to reflect changes in illiquidity and investor concerns about it. At the start of December 2010, for instance, the implied equity risk premium for the Wilshire 5000, a broad measure of all US stocks, was 6.28% whereas the implied equity risk premium for the Dow 30 was 4.55%. We assume, for convenience, that 4.55% is the equity risk premium for completely liquid stocks (liquidity beta of zero) and that the difference of 1.73% (6.28% - 4.55%) is the illiquidity risk premium.63


The inconsistency, though, is that Disney is one of the Dow 30 stocks and its liquidity beta is not zero, according to the calculations. One solution would be to crea

58 Bringing together these estimates, with conventional market betas that we estimates for Disney and Playboy yields liquidity-adjusted costs of equity for these firms in table 3: Table 3: Cost of equity Disney and Playboy Company Riskfree Market Rate Beta Liquidity Beta Equity Risk Premium for liquid equities 4.55% 4.55% Illiquidity Premium Cost of equity

Disney Playboy

3.32% 3.32%

1.01 1.20

0.71 1.40

1.73% 1.73%

9.14% 11.20%

There are two limitations with this approach. The first is that the liquidity betas are estimated with large standard errors; changing the parameters of the regression for Disney caused its liquidity beta to vary from 0.30 to 0.85, whereas the range for Playboys beta is even wider (0.45-1.70). The second is that that there is no input for investor characteristics. Thus, the same illiquidity-adjusted discount rate is used both by a short-term investor who values liquidity greatly and a long-term investor, less concerned about cashing out on his investment. b. Liquidity Proxy approach: In the last section, we referenced several studies that tried to quantify the impact of illiquidity on returns, by relating variation in returns to variations in liquidity measures. In one of the referenced studies, for instance, Amihud and Mendelson find that every 1% increase in the bid-ask spread (as a percent of the stock price) increases the annualized return by 0.25%. Applying this approach to estimate the cost of equity for Disney and Playboy would yield the results in table 4: Table 4: Liquidity Proxies: Costs of Equity Riskfree rate 3.32% 3.32% Equity risk premium 5.08% 5.08% Bid-ask spread as % Cost of of price equity 0.20% 8.45% 2.00% 9.42%

Disney Playboy

Beta 1.01 1.2

Note that we have reverted back to using a composite equity risk premium of 5.08% (the implied premium on the S&P 500) for US equities, and estimated an added premium, based on the bid-ask spread.

59 Portfolio Management For the last few decades, portfolio theory has pushed investors to diversify their wealth across asset classes and to hold multiple assets within each asset class. While illiquidity does not change this overall recommendation, it can significantly alter the mechanics of portfolio management as well as the composition of portfolios. Asset Allocation In the mean variance framework, an investment is measured on two dimensions, its expected return (which is the good dimension) and its standard deviation (the bad one). If we follow the framework to its logical conclusion, the optimal asset allocation mix for an investor is the one that maximizes expected return for a given level of standard deviation. It is this rationale that led to portfolio managers to invest in real estate in the 1980s and in private equity and hedge funds in the last decade. But what if there are significant differences in liquidity across asset classes? If real estate and private equity are less liquid than publicly traded equities and bonds, should that affect the asset allocation mix? The answer is clearly yes, but the extent to which the mix will change will depend upon the liquidity needs of the investor. At one extreme, consider an investor with significant cash needs in the near term and an uncertain or short time horizon. Investing in illiquid asset classes, even if they offer a good risk/return trade off, will expose the investor to significant losses, if investments have to be liquidated to meet cash needs. At the other extreme, an investor, with no cash needs for the short term and a long time horizon, will not be as concerned about liquidity. In fact, this investor may overweight his or her portfolio with illiquid assets during periods of crisis, because the risk/return trade off on these assets will be attractive (as illiquidity drives down the prices at which these assets sell). In effect, asset classes will have to be evaluated on three dimensions: the expected return, the standard deviation and the illiquidity of the asset class. The optimal asset mix for an investor will the one that maximizes expected return, subject to two constraints: that the risk of the portfolio be less than a specified level (which will be a function of the risk aversion of the investor) and that the liquidity of the portfolio exceed a minimal requirement (which will be determined by an investors liquidity needs). Cutting through

60 the details, here is the bottom line: the optimal mix of asset classes for an investor will reflect that investors liquidity preferences. Investors who value liquidity more (either because they are short term investors or because they need the cash) will tilt away from a liquidity-neutral mix (based upon market values) towards more liquid asset classes. Investors who value liquidity less, both because they are long term investors and need cash less, will tilt away from the liquidity neutral mix towards less liquid asset classes, because they will deliver much higher returns, given their risk. The tilt towards liquid asset classes on the part of investors who need and value liquidity and towards illiquid asset classes on the part of investors who value liquidity less should be accentuated during periods when market illiquidity is higher. To the extent that market liquidity itself varies over time, there is another dimension on which fund managers can differentiate themselves. Fund managers who can time changes in market liquidity will generate higher returns than those that do not, by adjusting their portfolios to hold more (less) liquid assets when markets are illiquid (liquid). Cao, Chen, Liang and Lo (2009) examine hedge fund performance from 1994 to 2008 and find evidence that hedge fund managers have liquidity timing abilities, in the aggregate. They decrease market exposure when market liquidity is low though they dont increase it when market liquidity is high. There are also wide variations across managers in liquidity timing, and it is a key determinant of success or failure in hedge funds that specialize in event driven, emerging market and convertible arbitrage strategies, where liquidity plays a much larger role in determining returns. Hedge funds that can time liquidity well generate 5-6% as excess returns on a risk adjusted basis.64 Security Selection Since liquidity and transactions costs vary across individual assets (stocks, bonds), there are three ways in which the differences can be incorporated into the asset selection process. The first is to compute expected returns, net of transactions costs; this will require that you estimate transactions costs realistically (including price impact and the bid ask spread) and that you consider your time horizon when investing. Note that the same stock can have different expected returns then to a short term investor than to a long

Cao, C., Y. Chen, B. Liang and A. Lo, 2010, Can hedge funds time market liquidity?, Working Paper, SSRN # 1537925.

61 term investor; the former has to spread the transactions costs over a much shorter holding period and thus faces a much bigger drop in expected returns. If security choices are made based upon these expected returns adjusted for transactions costs, investors who value liquidity more will invest less in illiquid companies (small cap stocks and low priced stocks) and more in liquid companies, when investing in equities, and less in lowrated corporate bonds and more in higher-rated corporate bonds and treasury bonds. The second and less involved way of bringing in liquidity into the security selection process is to use liquidity screens, in conjunction with traditional screens for price and fundamentals, to find investments. Thus, in addition to screening for stocks with low PE ratios (pricing screen) and high growth rates (fundamental screen), you would also look for high turnover ratios or trading volume as a liquidity screen. The tightness of the liquidity screen will vary across investors, depending upon their need for cash in the near term and preferences for liquidity. The third approach extends the standard portfolio optimization process to incorporate liquidity into your choices. Thus, rather than pick a portfolio that delivers the highest expected returns subject to a desired level of risk, you would explicitly list a liquidity constraint (stated in terms of transactions costs) that you want the portfolio to meet. Lo, Petrov and Wiersbicki (2003) provide an explicit description of how this process would work, using 50 stocks picked randomly across different market capitalization classes. They compare the standard optimal portfolio (computed based upon expected return and standard deviation) to a liquidity constrained optimal portfolio, using different measures for liquidity.65 Not surprisingly, they conclude that incorporating illiquidity costs into the decision process will increase the weights attached to more liquid assets and decrease those associated with less liquid assets. Note though, that, just as in the asset allocation process, variations in the demand for liquidity across investors implies that investors who value liquidity less than the rest of the market may be able to exploit that difference to buy illiquid investments at a discount.


Lo, A.W., C. Petrov and M. Wierzbicki. 2003, Its 11 pm Do you know where your liquidity is? The Mean-Variance-Liquidity Frontier, Journal of Investment Management, v1, 55-93.

62 Market Efficiency While we debate what constitutes trading costs and how to measure them, there is a fairly simple way in which we can estimate, at the minimum, how much trading costs affect the returns of the average portfolio manager. Active money managers trade because they believe that there is profit in trading, and the return to any active money manager has three ingredients to it: Return on active money manager = Expected ReturnRisk + Return from active trading - Trading costs Looking across all active money managers, we can reasonably assume that the average expected return has to be equal to the return on the market index. Thus, subtracting the average return made by active money managers from the return on the index should give us a measure of the payoff to active money management: Average ReturnActive Money Managers - Return on Index = Return from Active Trading Trading Costs Using this measure, the evidence is revealing. The average active money manager has underperformed the index in the last decade by about 1%. If we take the view that active trading adds no excess return, on average, the trading costs, at the minimum, should be 1% of the portfolio on an annual basis. If we take the view that active trading does add to the returns, the trading costs will be greater than 1% of the portfolio on an annual basis. There are also fairly specific examples of real portfolios that have been constructed to replicate hypothetical portfolios, where the magnitude of the trading costs are illustrated starkly. For decades, Value Line has offered advice to individual investors on what stocks to buy and which ones to avoid, and ranked stocks from 1 to 5 based upon their desirability as investments. Studies by academics and practitioners found that Value Line rankings seemed to correlate with actual returns. In 1979, Value Line decided to create a mutual fund that would invest in the stocks that it was recommending to its readers. In figure 11, we consider the difference in returns between 1979 and 1991 between the fund that Value Line ran and the paper portfolio that Value Line has used to compute the returns that its stock picks would have had.


The paper portfolio had an annual return of 26.2%, whereas the Value Line fund had a return of 16.1%. While part of the difference can be attributed to Value Line waiting until its subscribers had a chance to trade, a significant portion of the difference can be explained by the costs of trading. Looking at the evidence, there are three conclusions that we would draw. The first is that money managers either underestimate trading costs, over estimate the returns to active trading or both. The second is that trading costs are a critical ingredient to any investment strategy, and can make the difference between a successful strategy and an unsuccessful one. The third is that most market inefficiencies exist only on paper and in hypothetical studies and that incorporating the transactions and trading costs that investors face eliminates the paper profits. Corporate Finance How does introducing illiquidity into the discussion change corporate financial theory and policy? In our view, it will change how firms pick projects, how much debt they use to fund them and how much they pay out in dividends.

64 Investment Policy The objective in investment analysis is to make resource allocation decisions that maximize the value of the business. That objective does not change in an illiquid market but putting it into practice becomes more difficult to do. In this section, we will begin by looking at how the investment analysis process may have to be altered to account for differences in liquidity across investments and then consider how to incorporate illiquidity into costs of equity and capital. Investment Decision Rules The superiority of the net present value rule in investment analysis stems from the assumption that companies can access capital markets at no cost to raise new funding for any positive net present value rule. If we deviate from this assumption and introduce illiquidity into the process, the choice of decision rules becomes murkier. A valuemaximizing firm that faces liquidity constraints may not be maximizing its value by taking the highest positive net present value projects. In fact, the restrictions on raising new capital will require these firms to maximize the percentage returns they generate on limited capital. In fact, this is perhaps why the internal rate of return rule persists as a widely used investment decision rule. For those who are troubled by the potential for multiple internal rates of return and the faulty reinvestment rate assumption that underlies the IRR rule, there is an alternative. Continue to use the net present value rule as your primary decision rule but introduce liquidity constraints. For instance, the payback on a project measures the number of periods it will take for the cumulative cash flows to cover the initial investment. The investment decision rule can then modified thus: accept projects with a positive net present value, subject to the payback on the project not exceeding a specified limit. There are more sophisticated liquidity measures that can also be brought into the process, ranging from the computing and capping the duration on the project (where duration is defined as the weighted average maturity of the cash flows) and building in liquidity restrictions over multiple periods. Surveys of companies back up the linkage between liquidity and the choice of investment decision rules. Campbell and Harvey (2002) surveyed CFOs of US companies

65 and reported that while both techniques were widely used in capital budgeting, the usage of NPV was more common at large market cap companies, which are presumably more liquid. They also note that the second most commonly used capital budgeting technique is payback, with almost 57% of companies adopting it at least as a secondary decision rule.66 Cash flows (on liquid versus illiquid assets) In an earlier section, we listed many reasons why the computed cash flow on a project may not match up to the liquid cash flow. Cash flow computations can be adapted to meet concerns about liquidity. a. If the concern is that the firm may have to set aside cash flows to meet regulatory requirements, you could estimate cash flows after the set aside, thus assuming that the regulatory capital in untouchable as a cash flow, as long as the firm remains a going concern. b. If there are state restrictions or lender covenants on how much a firm can return to investors, the cash flow can be capped to reflect the restrictions and the residual amount can be carried forward until the constraint eases. This time delay may reduce the present value of the cash flows, especially if the carried forward cash has to be invested at below-market rates. c. If there are sovereign remittance restrictions on cash flows, and the value of a foreign project is being computed to domestic investors, the cash flow that is discounted will reflect only that portion of the cash flows that can be remitted. The unremitted balance will be held, earning the appropriate returns or interest, until remittance is feasible (perhaps after a specified period or when the project winds up). Here again, the net effect will be the potential loss in value that occurs in that period. d. If the cash flows are in a currency that is not liquid, there is the risk that conversion rate may be very different from the current exchange rate. To the extent that you can enter into privately negotiated forward contracts to protect these cash flows from exchange rate effects, the expected cash flows on the

Graham, John R., and Campbell Harvey, 2002, How Do CFOs Make Capital Budgeting and Capital Structure Decisions?, Journal of Applied Corporate Finance 15, 8-23.

66 project can be reduced by the costs of buying this insurance (which can be substantial). In summary, as cash flows on a project become less liquid, the value of the project will decrease. The fact that all cash flows are not equally liquid can have implications for investment analysis. Firms that face stricter liquidity constraints are also less likely to invest in longer term projects and especially so if those projects have cash outflows in the earlier years and inflows in the future (such as infrastructure investments in capital intensive businesses). Holding all else constant, you would also expect firms to invest less in countries with significant remittance restrictions or illiquid currencies. Cost of equity and capital As we noted earlier, the costs of equity and capital in conventional corporate finance are computed on the implicit assumption that equity and debt markets and completely liquid and accessible. However, we also looked at evidence that not only are there differences in liquidity across companies but that market illiquidity itself can vary over time. Incorporating illiquidity in the costs of financing will push the costs up, but how exactly can we incorporate liquidity into costs? We have two choices: a. Gross up for transactions costs: A simple way of incorporating transactions cost is to gross up the cost of financing for the upfront transaction costs borne in raising the financing. Assume that a firm is planning to raise $ 100 million in new equity capital and that the conventional measure of cost of equity, based on the market beta or betas, is 9%/. Assume also that the issuance cost from investment banking fees is 10%. The grossed up cost of equity for this firm can be computed as follows: Gross Cost of equity =

Conventional Cost of Equity 9% = = 10% (1! Issuance Cost as a % of proceeds) (1!.10)

While this approach is simple, it has two problems. It works best when illiquidity is an upfront cost that can be quantified but not as well when illiquidity is a continuing problem that creates costs over time. The second is that it creates a two tier cost for

67 equity, where internal equity (retained earnings) as a lower cost than external equity (new stock issues). b. Adjust for liquidity risk explicitly: In the valuation section, we developed an alternative way of adjusting the cost of equity for illiquidity explicitly, by estimating an illiquidity beta (jl) for a company (that captures how illiquidity in the company covaries with market illiquidity) and an illiquidity risk premium (LRP): Cost of equity = R f + ! jm ( ERP ) + ! jl (LRP) where jm is the conventional market beta measure and ERP is the equity risk premium. The adjustment for illiquidity in the cost of debt should be simpler, since lenders will charge higher interest rates during periods of illiquidity and default spreads will reflect their preferences. The net effect of using either approach is a higher cost of capital for illiquid companies than for otherwise similar liquid companies and an increase in the cost of capital during periods of market illiquidity. What are the implications? Since liquid companies will have lower costs of capital than their less liquid competitors, it can operate as a competitive advantage in sectors where there are wide variations in access to capital, and can be a potential source of synergy in acquisitions of illiquid, smaller companies by their more liquid, larger counterparts. This may also explain why some larger market-cap emerging market companies choose to get listed on developed markets; many Latin American and Asian firms have depository receipts (ADRs) listed on the New York Stock Exchange. Listing on a more liquid market can lower your cost of capital and increase firm value. Chan, Hong and Subrahmanyam (2007) examine the pricing of ADRs on 401 companies and attribute the differences in premiums (over the local market listing price) to differences in liquidity.67 Capital Structure In a liquid market, firms should choose the mix of debt and equity that minimizes their cost of financing and/or maximized value, and match debt up to these assets. As

Chan, J. S. P., Hong, D., and Subrahmanyam, M. G., 2007. A tale of two prices: Liquidity and asset prices in multiple markets, Journal of Banking & Finance 32, 947-960.

68 illiquidity costs rise, the trade off on using debt as opposed to equity also will change and alter both the optimal mix for the firm and the right type of debt to use. How much debt to use The items in the debt trade off are unchanged in a world with illiquidity: tax benefits as a plus and expected bankruptcy costs and agency costs (between debt and equity investors as a minus). What illiquidity does change is the magnitude of these items and through them the optimal mix. We can examine the effect of illiquidity using either of the two approaches that we described in the earlier section. In the cost of capital approach, there are two ways in which illiquidity plays out in the optimal debt ratio. First, the illiquidity of financial markets affect both the cost of equity and debt. To the extent that illiquidity is more of a problem in one market than in another, the optimal mix will be different. Thus, if equity markets are very illiquid but bank funding is more accessible, as is the case in many smaller emerging markets, the cost of equity will rise far more than the cost of debt, when illiquidity is incorporated, leading to higher optimal debt ratios. Thus, the effect of financial market illiquidity on optimal debt ratios in the cost of capital approach is ambiguous and depends in large part on the relative illiquidity of the two markets. Second, the illiquidity of asset markets can affect the costs of equity and debt, with the impact being larger on the cost of debt and here is why. To the extent that lenders base interest rates on their expectations that a firm will default and the proceeds from asset sales, if default occurs, they will charge higher interest rates when asset markets are illiquid than when they are liquid. Equity investors are less reliant on liquidation value for their payoffs and thus less likely to increase their required returns to compensate for illiquid asset markets. The net effect should be a reduction in optimal debt ratios for firms, with the impact increasing with the illiquidity of firms. Incorporating both financial market and asset market illiquidity into the cost of capital will generally reduce optimal debt ratios for firms. In the adjusted present value approach, the effect is more clear-cut. The probability of default increases across the board as illiquidity in capital markets increase. A firm that is unable to access capital markets, is more likely to find itself defaulting

69 when debt payments come due. The cost of bankruptcy increases as illiquidity in asset markets increases, since asset sales will deliver less in proceeds. Holding tax benefits constant, the value added by debt will therefore decrease as illiquidity increases. There have been studies that back up the linkage between the liquidity of securities issued by firms and capital structure. Lipson and Mortal (2009) focus on equity market liquidity and look at debt ratios for firms, classified based into liquidity quintiles, and note that firms with more liquid stocks tend to have lower debt ratios than firms with more illiquid stock; they also document that increasing leverage can increase equity market volatility and liquidity.68 Rajan and Zingales (1995), in their comparison of capital structure, across markets also find evidence of higher debt ratios in markets with less liquid equity markets, though those differences can be attributed to factors other than liquidity.69 Other studies have examined the linkage between asset market liquidity and capital structure; if asset markets are illiquid, selling assets in the face of distress becomes more difficult and costly, thus also increasing the cost of distress (and lowering the net payoff to borrowing money). Alderson and Baker (1995) note that firms that face high asset liquidation costs tend to borrow less money70 and Kim (1998) finds that firms in the contract drilling business with more liquid assets tend to borrow more than firms with less liquid assets.71 Benmelech, Garmaise and Moskowitz (2005) examine loans on commercial property and find that higher asset liquidity goes with greater loan size.72 Type of Debt Rather than match debt up to assets, which is the optimal policy when all markets are liquid, a firm should borrow money or issue bonds in the most liquid markets and use derivatives or forward contracts to reduce the mismatch risk. For instance, the US firm


Lipson, M., and S. Mortal, 2009, Liquidity and Capital Structure, Journal of Financial Markets 12, 611644. 69 Rajan, R., and L. Zingales. What Do We Know About Capital Structure? Some Evidence from International Data. Journal of Finance, 50 (1995), 1421-1460. 70 Alderson, M., and B. Betker. Liquidation Costs and Capital Structure. Journal of Financial Economics, 39 (1995), 45-69. 71 Kim, C. The Effects of Asset Liquidity: Evidence from the Contract Drilling Industry. Journal of Financial Intermediation, 7 (1998), 151-176. 72 Benmelech, E.; M. Garmaise; and T. Moskowitz. Do Liquidation Values Affect Financial Contracts? Evidence From Commercial Loan Contracts and Zoning Regulation., Quarterly Journal of Economics, 120 (2005), 1121-1154.

70 with an Indonesian project, with rupiah cash flows, should issue US dollar bonds and then use rupiah-dollar forward contracts or options to hedge against the exchange rate mismatch. It is possible that some of the mismatches that emerge from this strategy cannot be easily hedged. Thus, a firm that is forced to borrow short term to fund long term projects, because banks will not lend long term or charge exorbitant rates to do so, is facing additional default risk. As a consequence, it should scale down how much it borrows to reflect this concern. The empirical evidence on the relationship between debt type and liquidity is limited. One study of how firms coped with the banking crisis of 2008, where both equity and debt markets became illiquid for almost all firms, provides some insight. It notes that firms that could access lines of credit were able to alleviate the impact of illiquidity better than firms without that access.73 Studies that compare financing choices across countries also find that firms in less liquid markets tend to be more dependent on short-term bank debt than firms in developed, more liquid markets. While there are other factors that play into these choices, having a long-term relationship with a bank can provide access to capital during liquidity crises. Dividend Policy When liquidity is not a concern, companies should return excess cash to their stockholders, the choice of dividends and stock buybacks as a cash return mechanism will be determined by tax considerations and firms should maintain only operating cash balances. However, all of these recommendations have to be modified when liquidity becomes a concern. Cash returned versus Cash held back Consider a firm that generates $ 100 million in after-tax cash flows that are in excess of it operating and reinvestment needs. Should this firm return the cash to stockholders? The cash is excess cash, at least for this period, and returning it does not adversely impact the firm at least for the near term. However, what if the firm has a cash deficit next period of $ 100 million, either because its operating cash flows drop or
Campello, M., E. Giambona, J.R. Graham and C.R. Harvey, 2010, Liquidity Management and Corporate Investment during a Financial Crisis, Working paper, Duke University.

71 because its reinvestment needs surge? In a liquid market, the firm faces no problem. It will raise the $ 100 million, accessing either debt or equity markets, and cover its deficit. But what if markets are either illiquid or can become illiquid? This firm may be unable to raise $ 100 million in the next period and face all of the consequences, which can range from the unpleasant (investment cutbacks and lower growth) to the catastrophic (bankruptcy). It follows, therefore, that a forward-looking firm will hold back on the excess cash of $ 100 million in the first period to cover the potential deficit in the second. This very simplistic illustration brings home the two key changes that you would expect in dividend policy, as you introduce either actual illiquidity or the fear of illiquidity in the future into the discussion. The first is that we should expect less cash to be returned to stockholders as illiquidity increases, as a percent of available cash flow, with firms that are more exposed to illiquidity risk (smaller and riskier firms) holding back more cash. The second is that the cash balances at firms should also increase as illiquidity concerns rise, with the increase being proportionately greater at firms that are more exposed to illiquidity risks. Almeida, Campello and Weisbach (2004) use a large sample of manufacturing firms to examine how cash holdings at firms vary as a function of the financial constraints they face; they use multiple proxies for these constraints including payout ratios, firm size and bond ratings.74 They conclude that firms that face more constraints in raising capital are more likely to withhold cash and have larger cash balances. In direct evidence of the proposition that fears of illiquidity affect cash balances at any given company, a survey of CFOs of US companies by the Association of Finance Professionals in 2010 found that twice as many firms increased their cash balances as decreased them after the banking crisis in 2008.75 Dividends versus Stock buybacks On the issue of dividends versus stock buybacks, illiquidity can play a role in the choice. Consider a limiting example. Assume that, investors live in a world with no taxes. To be indifferent between dividends and stock buybacks (of equal magnitude), they

Almeida, H., M. Campello, and M. S. Weisbach, 2004, The cash flow sensitivity of cash, Journal of Finance 59, 1777-1804. 75 2010 AFP Liquidity Survey, Association of Finance Professionals, Maryland. (

72 should both deliver the same cash flow to investors. The cash flow from dividends arrives directly to investors and requires no assumptions about market liquidity. To get the equivalent cash flow from buybacks, investors who were not part of those who sold their shares back to the company at the time of the buyback, have to be able to sell a portion of their holdings at the higher post-buyback price to collect the cash flow. Illiquidity clearly matters at that stage and can thus make dividends a more attractive option than buybacks of the same dollar value. In practical terms, this would imply that stocks that pay high dividends should be priced more highly than otherwise similar stocks that pay lower dividends. The argument that firms in less liquid markets should pay more dividends may seem to contradict the conclusion in the last section, where we argued that they are likely to hold back cash and accumulate large cash balances. Bringing in stock buybacks as an alternative approach to returning cash to stockholders resolves the contradiction. Firms in more liquid markets will have less incentive to accumulate cash, but they will also be rewarded less by investors for paying dividends; they are more likely to use stock buybacks. Firms in less liquid markets have a more difficult balancing act: they want to accumulate larger cash balances but investors also prefer larger dividends. Not surprising, they are less inclined to buy back stock; this may be part of the reason why buybacks are far more common in the United States than in emerging markets. Within the same market, we should also expect to see stock buybacks rise when markets are liquid and decrease when concerns about market liquidity increase. That again may be part of the reason why stock buybacks came to an almost complete standstill in the United States in the aftermath of the banking crisis (which was also a liquidity crisis) of 2008. The evidence backs up the proposition that liquidity and dividends are negatively related. Banerjee, Gatchev and Spindt (2007) find evidence that less liquid firms are more likely to initiate and increase dividends than more liquid firms and argue that declining dividends at US firms can be attributed at least partially to increased liquidity in US equity markets.76 Looking across countries, Griffin (2010) notes a greater propensity to


Banerjee, S., V. Gatchev, and P. Spindt, 2007. Stock market liquidity and firm dividend policy, Journal of Financial and Quantitative Analysis 42, 369-398.

73 pay dividends in countries with less liquid stock markets.77 While there is no direct evidence linking buybacks to liquidity, the fact that buybacks are more common in the US than in other markets and that more liquid, large market capitalization companies are more likely to buy back stock is consistent with the hypothesis that more liquid firms are more likely to buy back stock.78

Illiquidity matters. Investors are generally willing to pay higher prices for more liquid assets than for otherwise similar illiquid assets. While this proposition is widely accepted, there is substantial debate about how to measure illiquidity and to incorporate it into value. In the first part of this paper, we look at how assumptions about liquidity are critical to how we approach portfolio management and corporate finance. In the second part, we look at the empirical evidence on how much liquidity varies across investments and across time, and how much markets value liquidity. Considering a broad array of investments, from government bonds to private equity, the consensus conclusion that we draw is that illiquid investments trade at lower prices than liquid investments and generate higher returns. The magnitude of the illiquidity discount varies across investments, with riskier investments bearing larger illiquidity discounts, and across time, with the discounts being greatest when the overall market itself is least liquid. In the next part of the paper, we consider the effects of incorporating liquidity (or its absence) into the analytical process for both investors and financial managers. For investors, it pinpoints the importance of finding an investment strategy that matches time horizon; less liquid investments can be a bargain to long-term investors and the capacity to forecast shifts in market liquidity can deliver superior returns. For financial managers, the perceived liquidity of the firms securities and its assets can affect investment, financing and dividend policy. In general, firms with that face illiquid markets will invest less in long-term projects, use debt sparingly, accumulate more cash and pay higher dividends.


Griffin, C.H., 2010, Liquidity and Dividend Policy: International Evidence, International Business Research, v3, 3-9. 78 There is some evidence of a reverse causality: trading volume increases and liquidity improves after buybacks.