Liquidity and Volatility

Itamar Drechsler, Alan Moreira and Alexi Savov

No 27959, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E44 G12 G23 (search for similar items in EconPapers)
Date: 2020-10
New Economics Papers: this item is included in nep-fmk, nep-mac and nep-rmg
Note: AP
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Citations: View citations in EconPapers (2)

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