Market Liquidity and Flow-driven Risk

Deuskar, P and Johnson, T C (2011) Market Liquidity and Flow-driven Risk. The Review of Financial Studies, 24 (3). pp. 721-753.

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Abstract

Using a unique dataset of trades and limit orders for S&P 500 futures, we decompose the aggregate risk into a component driven by the impact of net market orders and a component unrelated to net orders. The first component flow-driven risk is large, accounting for approximately 50% of market variance, and it is not transient. This risk represents the joint effect of net trade demand and the price impact of that demand—i.e., illiquidity. We find that flows are largely unpredictable, and lagged flows have no price impact. Flow-driven risk is time varying because the price impact is highly variable. Illiquidity rises with market volatility, but not with flow uncertainty. Net selling increases illiquidity, which amplifies downside flow-driven risk. The findings are consistent with flow-driven shocks resulting from fluctuations in aggregate risk-bearing capacity. Under this interpretation, investors with constant risk tolerance should trade against such shocks (i.e., “supply liquidity”) to achieve substantial utility gains. Quantitatively accounting for the scale of flow-driven risk poses a major challenge for asset pricing theory.

Affiliation: Indian School of Business
ISB Creators:
ISB CreatorsORCiD
Deuskar, PUNSPECIFIED
Item Type: Article
Additional Information: The research paper was published by the author with the affiliation of University of Illinois.
Uncontrolled Keywords: Liquidity, Market Liquidity, Quantitatively accounting
Subjects: Finance
Depositing User: Ilayaraja M
Date Deposited: 17 May 2019 16:08
Last Modified: 17 May 2019 16:49
URI: http://eprints.exchange.isb.edu/id/eprint/1011
Publisher URL: https://doi.org/10.1093/rfs/hhq132
Publisher OA policy: http://sherpa.ac.uk/romeo/issn/0893-9454/
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