Liquidity has been called the water of life in the banking sector – but what about financial markets as a whole? Turns out that liquidity risk is a major force that can trigger widespread stock market crashes, with one notable exception: the 2007-2008 liquidity crisis, which stemmed from the banking industry.
In their paper, “Time-Varying Crash Risk: The Role of Stock Market Liquidity,” authors Peter Christoffersen, Bruno Feunou, Yoontae Jeon, Chayawat Ornthanalai examine the impact of market liquidity risk on the volatility and crash probability of the stock market, proxied by the S&P 500 index. Their paper will be presented at the Northern Finance Association Conference being held in Mont Tremblant, Quebec, from September 16-18 2016.
Using daily S&P 500 index options between 2004 and 2012, the authors find that 64% of time-varying crash risk is due to the stock market’s exposure to market illiquidity. “This is with an exception of the 2008 crisis, when the influence of spot variance dominates and the contribution of market illiquidity falls to about 30%,” the authors note.
Plan sponsors take note: as regulators continue to curb the role of banks in financial markets, investors – not banks – will increasingly bear the risk of market illiquidity. That means the influence of market liquidity on the overall economy will be increasingly important the authors conclude.
You can view the full paper here – and view the Northern Finance Conference agenda here.