Liquidity and Volatility

73 Pages Posted: 19 Oct 2020 Last revised: 24 Nov 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: October 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. As aggregate volatility shocks carry a very large premium in option markets, this negative exposure can explain why liquidity provision earns high average returns. We show this by incorporating uncertainty about the amount of private information into an otherwise standard model. 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 their average returns with the same risk price as in option markets, and their predictability by VIX in the time series. 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.

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Suggested Citation

Drechsler, Itamar and Moreira, Alan and Savov, Alexi, Liquidity and Volatility (October 2020). NBER Working Paper No. w27959, Available at SSRN: https://ssrn.com/abstract=3714451

Itamar Drechsler (Contact Author)

Wharton School, Department of Finance ( email )

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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 )

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