Greater market liquidity actually increases risk: study

July 25, 2018, American Associates, Ben-Gurion University of the Negev

Contrary to most common theories that greater liquidity is necessarily better for financial markets overall, Ben-Gurion University of the Negev (BGU) researchers contend in a new paper that liquidity comes at cost: it increases market risk.

Prof. Haim Kedar-Levy of the BGU Department of Management and Prof. Shmuel Hauser of the Department of Business Administration in the Guilford Glazer Faculty of Business and Management presented their theory in "Liquidity might come at cost: The role of heterogeneous preferences" at the 25th Annual Conference of the Multinational Finance Society held in Budapest, Hungary.

Financial literature contends that of specific assets, such as a stock, is an important and positive attribute that can reduce risk and add value to the stock. Kedar-Levy and Hauser agree, however their findings on the impact of liquidity on the whole market is different.

"The model we developed is richer than the classic theory because, among other reasons, it takes into account a more realistic treatment of in which various investors have different investment strategies," the researchers say. "Investors differ in the amount of risk they are willing to assume, and therefore choose different proportions of investments in risky assets, such as equities."

In this more realistic scenario, the study shows that the more liquid the market is, the more volatile becomes the average appetite for risk in the whole market. At reasonable risk appetite parameters, trading volume and liquidity of the stock market as a whole peak. When that occurs, there is a massive exchange of shares between investors with different risk appetites. This attribute causes the market price of risk (a.k.a. Sharpe ratio) to be highly volatile, and makes all stocks more risky.

The Sharpe ratio measures how much excess return an is receiving for the extra volatility that he endures for holding a riskier asset. Investors need to be compensated for the additional risk vs. holding a risk-free asset, like cash.

However, if the investors in the market are either very similar or very different in their appetite for risk, then trading volume and liquidity drop, and risk declines, as well.

"This is not to say that we favor less liquid markets over highly liquid ones, but we find that liquidity comes at cost," the researchers say. "It is not a free attribute of markets."

The study was published in the Journal of Financial Markets.

Explore further: Bank network shifts signaled financial crisis—and may prevent another

More information: Shmuel Hauser et al, Liquidity might come at cost: The role of heterogeneous preferences, Journal of Financial Markets (2018). DOI: 10.1016/j.finmar.2018.03.001

Related Stories

Why do investors seek out stock swindles?

January 29, 2018

The chance to get rich quick by investing in a penny stock, even if it is widely suspected that the stock price is being manipulated, is too tempting for some investors to resist.

Recommended for you

Sculpting stable structures in pure liquids

February 21, 2019

Oscillating flow and light pulses can be used to create reconfigurable architecture in liquid crystals. Materials scientists can carefully engineer concerted microfluidic flows and localized optothermal fields to achieve ...

Researchers make coldest quantum gas of molecules

February 21, 2019

JILA researchers have made a long-lived, record-cold gas of molecules that follow the wave patterns of quantum mechanics instead of the strictly particle nature of ordinary classical physics. The creation of this gas boosts ...

LMC S154 is a symbiotic recurrent nova, study suggests

February 21, 2019

Astronomers have conducted observations of a symbiotic star in the Large Magellanic Cloud (LMC), known as LMC S154, which provide new insights about the nature of this object. Results of these observations, presented in a ...


Please sign in to add a comment. Registration is free, and takes less than a minute. Read more

Click here to reset your password.
Sign in to get notified via email when new comments are made.