The Risky Business of Liquidity

Investor risk perceptions can heavily influence international stock liquidity, a study has found.

The more risk investors perceive in equity markets, the more illiquid global markets tend to become, according to new research.

While uncertainty has long been considered a factor in illiquidity in US equities, Massey University PhD candidate Rui Ma and finance professors Hamish Anderson and Ben Marshall took the theory one step further. They argued that investors’ risk perceptions are an important determinant of overall international stock market liquidity.

“The influence of investor risk perception on liquidity is both statistically significant and economically meaningful in global markets after controlling for other well-documented market-level determinants of liquidity,” the authors wrote.

Using the Chicago Board Options Exchange Market Volatility Index (VIX)—also known as the ‘fear gauge’—as a proxy for investor risk perception, Ma, Anderson, and Marshall examined how investor uncertainty affected the liquidity of 45,564 individual stocks from 57 countries between 1990 and 2015.

In a given month, a 1% VIX increase boosted illiquidity ratios by 0.7%. The impact was even higher in countries that were more open or economically developed—despite developed market equities being “generally more liquid” and providing better investor protections.

“Countries which are more open to world markets and countries with low information asymmetry attract more global investors, and therefore are more affected by investor risk perception in global markets,” the researchers wrote.

Market liquidity was also more sensitive to risk perceptions in countries with no short-selling constraints, better governance environments, larger market capitalizations, greater trading volumes, and lower market return volatility.

Though Ma, Anderson, and Marshall admitted that it was possible that heightened illiquidity could be the cause of higher investor uncertainty, their study found no reverse causality.

“A shock in VIX has a significantly positive and long-lived impact on world illiquidity,” they concluded.

Related: Liquidity Crisis? We Can Cope, Say Managers