A MICRO LOOK AT THE STOCK MARKET
Price jumps aren’t driven by liquidity
BY Richard Westlund

Financial analysts and investors know that major political and economic shocks have ripple effects across the global financial markets. But this issue of liquidity – the availability of funds for buying and selling of equities – is also believed to play a role in the ups and downs of the stock market.
 
Richard Roll, Linde Institute Professor of Finance at California Institute of Technology, has examined these financial and behavioral relationships from a micro perspective and reported his findings at the School’s Seventh Behavioral Finance Conference, in the keynote speech, “The Propagation of Shocks Across International Equity Markets: A Microstructure Perspective.”

Using big data research tools, Roll tracked changes in equity market returns (price), quoted spreads, effective spreads, aggregate turnover and order imbalances at five-minute intervals during trading days on major exchanges in 12 counties from 1996 to 2011. He used a sophisticated algorithm to identify positive or negative jumps – changes at opposite ends of a normal bell curve – during those intervals, and looked for correlations with variables that could create those changes.

“There is a huge literature on the issue of market volatility,” Roll said. But, he added, analysts are still trying to understand the driving factors behind the October 1987 crash, the factors behind the Mexican, Southeast Asian and Latin American crises in the 1990s and the relatively slow unfolding of the global financial crisis in 2007 and 2008.

Roll said lack of market liquidity is often mentioned as a causative factor in market downturns, as investors liquidate their holdings, leading to an imbalance in trading activity and driving prices down. Order imbalances can also drive prices higher, as investors seek to buy more shares of a particular stock than there are available for sale – leading buyers to raise the price they’re willing to pay until it lures enough sellers.

But it’s broad economic news that has the most impact on markets. “Macroeconomic news events are linked to those order imbalances and price jumps, both positively and negatively,” Roll said. For example, he noticed that about 40% of the price jumps or declines in European markets occurred soon after a relevant U.S. news announcement.

“After the announcements, stock prices tended to stay up or down, suggesting those changes were driven by information rather than liquidity issues,” he said. Otherwise, prices could be expected to revert to “normal” as a temporary liquidity shortage resolves itself.

Roll’s study resulted in other interesting findings. For example, short-term price jumps occurred more in certain markets like Hong Kong, Japan and Malaysia, than in others like India, Brazil and Mexico. During the 15-year study period, Roll found 872 five-minute intervals with a jump in the Hong Kong market, compared with 300 in the U.S. markets and 87 in India’s markets.
 
He also found that a liquidity problem in one market – such as an imbalance between sell and buy orders – doesn’t necessarily have a spillover effect in other markets, although there might be ripples within a region, such as China or Latin America. “This also speaks against the idea that liquidity shortages are responsible for major financial crises,” he said.

Spring 2017
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