Two essays in dynamics of stock liquidity and asset returns
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This dissertation consists of two essays. In the first essay, we study how the correlations between stock portfolios and Treasury bonds vary jointly with the stock’s volatility and the stock’s illiquidity. Our goals are to: (1) better understand time-variation in stock-bond correlations, (2) help distinguish between flight-to-quality and flight-to-liquidity pricing influences, and (3) evaluate the performance of alternate liquidity metrics in this setting. In the time series, we find that aggregate stock market illiquidity is negatively associated with the future stock-bond return correlation, although the illiquidity relation is generally weaker than the negative volatility-correlation relation. However, in the cross-section of stocks during times of market stress, a stock’s illiquidity is more informative about the cross-sectional variation in the correlation changes than is a stock’s volatility. Thus, stock volatility appears better at identifying the times when stock-bond correlations become more negative, but illiquidity appears better at identifying which stocks have stronger correlation variation. In our setting, the Amihud (2002) price impact measure of illiquidity performs better than Pastor and Stambaugh (2003) return reversal measure of illiquidity. The second essay characterizes the movements and co-movements in stock market volatility, illiquidity and idiosyncratic volatility. We examine the commonality in the three variables when moving from good times to bad times by studying regime-switching models. We find that the regimes identified by using one or two or all three of the variables have similar characteristics. This suggests that these variables are closely related and may, to some extent, be capturing the same information about the market environment. Our Granger-causality tests suggest that each of these series have some ability in forecasting the other two series. Our findings have important implications on research that examine if these variables affect stock returns. We show that a study that only examines the relation between returns and market volatility may attribute a return pattern to price-volatility effects, when it might be more of price-liquidity effect (or some combination of the two effects).