Liquidity and Volatility

74 Pages Posted: 8 Mar 2018 Last revised: 19 Oct 2021

See all articles by Itamar Drechsler

Itamar Drechsler

Wharton School, Department of Finance; National Bureau of Economic Research (NBER)

Alan Moreira

University of Rochester - Simon Business School

Alexi Savov

New York University (NYU) - Department of Finance; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: September 28, 2020

Abstract

Liquidity provision is a bet against private information: if private information turns out to be higher than expected, liquidity providers lose. Since information generates volatility, and volatility co-moves across assets, liquidity providers have a negative exposure to aggregate volatility shocks. Aggregate volatility shocks carry a large premium, hence this negative exposure explains why liquidity provision earns high average returns. We show this by incorporating uncertainty about the amount of private information into an otherwise standard model of liquidity provision. We test the model in the cross section of short-term reversals, which mimic the portfolios of liquidity providers. As predicted by the model, reversals have large negative betas to aggregate volatility shocks. These betas explain reversals' average returns with the same price of volatility risk that prevails in option markets. Volatility risk thus explains the liquidity premium among stocks, and why it increases in volatile times. Our results provide a novel view of the risks and returns to liquidity provision.

Keywords: liquidity, volatility, reversals, VIX, variance premium

Suggested Citation

Drechsler, Itamar and Moreira, Alan and Savov, Alexi, Liquidity and Volatility (September 28, 2020). Jacobs Levy Equity Management Center for Quantitative Financial Research Paper, Available at SSRN: https://ssrn.com/abstract=3133291 or http://dx.doi.org/10.2139/ssrn.3133291

Itamar Drechsler (Contact Author)

Wharton School, Department of Finance ( email )

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HOME PAGE: http://https://sites.google.com/site/idrechsl/

National Bureau of Economic Research (NBER) ( email )

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Alan Moreira

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

Alexi Savov

New York University (NYU) - Department of Finance ( email )

Stern School of Business
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New York, NY 10012-1126
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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