ILLIQUIDITY IN THE STOCK AND FOREIGN EXCHANGE MARKETS: AN INVESTIGATION OF THEIR CROSS‐MARKET DYNAMICS

• DOI: http://doi.org/10.1111/jfir.12113
• Author: Chiara Banti
• Published date: 01 December 2016
• Date: 01 December 2016

ILLIQUIDITY IN THE STOCK AND FOREIGN EXCHANGE MARKETS: AN

INVESTIGATION OF THEIR CROSS-MARKET DYNAMICS

Chiara Banti

University of Essex

Abstract

In this article, I investigate the illiquidity channel linking stocks and currencies and

provide evidence of important illiquidity dynamics, especially during crisis episodes.

I show that the stocks of small firms more exposed to funding constraints also exhibit

greater linkages with foreign exchange illiquidity. Furthermore, the currencies that are

common targets of carry trades are more intertwined with stock illiquidity. Regarding

potential determinants, the liquidity demand by institutional investors and liquidity

provision by dealers are potential triggers of systemic illiquidity spirals. These dynamics

are not exclusive to the recent financial crisis but were also present during the dot-com

bubble crisis.

JEL Classification: G01, G15, G20

I. Introduction

The subprime mortgage market turbulence in the summer of 2007 was characterized by

sharp drops in asset prices, increasing volatility, and episodes of liquidity dry-ups. Most

of the literature focuses on the dramatic reactions of the stock and bond markets.

However, the crisis has been systematic from its beginning and has severely affected the

foreign exchange (FX) market. Indeed, Melvin and Taylor (2009) document the large

losses in currency trading strategies, especially the carry trade, from August 2007. They

also show that the dynamics of currency bid–ask spreads during the crisis were largely

affected by factors originating outside the FX market. The literature has established

returns and volatility linkages between currencies and stocks, but the illiquidity linkage

has received little attention.

In this article, I investigate the illiquidity channel linking currencies and stocks.

Illiquidity is a broad concept that comprises different aspects. I focus on bid–ask spreads

and study how shocks to transaction costs are transmitted across markets and what

factors may trigger these dynamics. Understanding illiquidity dynamics is especially

important when liquidity is scarce. Indeed, a large body of literature emerged following

I am grateful to Geir Bjonnes, Giovanni Cespa, Jerry Coakley, Neil Kellard, Michael Lamla, Steve Lawrence

and State Street Associates, Ian Marsh, Lukas Menkhoff, Carol Osler, Kate Phylaktis, Lucio Sarno, Maik

Schmeling, Barbara Ulloa, Dhang Zheng, the editors, and the anonymous referee, as well as the participants at the

12th INFINITI conference, the 6th IFABS conference, the Southern Finance Association annual meeting in Key

West (FL), and the 2nd Women in Microstructure Meeting in Park City (UT) for useful suggestions and comments.

I would like to thank Doug Richardson and ICI for providing the data on mutual funds.

The Journal of Financial Research Vol. XXXIX, No. 4 Pages 411–435 Winter 2016

411

© 2016 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

the recent financial crisis to study illiquidity and identify its determinants (e.g.,

Brunnermeier and Pedersen 2009). I follow the literature and analyze illiquidity

dynamics during the recent financial crisis (2007–2009). Moreover, I investigate whether

these dynamics are exclusive to this crisis or common in market turbulence, focusing on

two other episodes: the dot-com crisis (2000–2001) and the European sovereign debt

crisis (2010–2014).

The cross-market linkages between stock and currency returns originate from a

variety of factors. For instance, commonality in stocks and currencies may originate from

international investors rebalancing their portfolios (e.g., Hau and Rey 2005; Hau, Massa,

and Peress 2010). Moreover, popular trading strategies link the two markets. For

instance, “global macro”and “multistrategy”are strategies that involve simultaneous

trading in stocks and currencies.

1

Additionally, arbitrageurs may exploit price

mismatches between cross-listed stocks. There is evidence of comovement between

FX and stock liquidity (Mancini, Ranaldo, and Wrampelmeyer 2013; Karnaukh,

Ranaldo, and S€

oderlind 2015). To the best of my knowledge, this article is the first

investigation of the dynamics of the illiquidity mechanisms linking stocks and

currencies, with particular attention to illiquidity spirals. The focus is on the NASDAQ

and the major FX electronic trading platforms (Reuters and EBS). These segments are

representative of significant portions of trading in stocks and currencies and share

important similarities in their structure (see Section II).

Identification of theilliquidity channel linking stocks and currencies is relevantin

different respects. As a measure of frictions, illiquidity affects market efficiency. Hence,

identification of interdependencies in the illiquidity of financial marketscontributes to the

understanding of the processes toward market efficiency (Chordia, Roll, and

Subrahmanyam 2008). Furthermore, the presence of illiquidity spillovers across markets

has implications for asset management. Asness, Moskowitz, and Pedersen (2013) find a

significant correlation between the returns of trading strategies in stocks and currencies,

determined by their exposure to liquidity risk. In addition, liquidity risk is priced in the

cross-section of both asset returns (Pastor and Stambaugh 2003; Banti, Phylaktis, and

Sarno 2012).Thus, understanding the sources of these linkagesis relevant for asset pricing.

The systemic dimension of liquidity also has important policy implications, given the

severe costsand negative externalities associatedwith its sudden dry-ups. These have been

particularly severe during the recent financial crisis.

I identify cross-market illiquidity dynamics between stocks and currencies by

conducting a vector autoregression (VAR) analysis of daily transaction costs from 1999

to 2014. The observed illiquidity linkages depend on certain asset characteristics. In

particular, I find that during the recent financial crisis, stocks of smaller firms (also called

small caps) are more strongly related to currencies than stocks of larger firms (large

caps). In turn, I find that the relation between the illiquidity of currencies and small caps

depends on currencies’role in the carry trade. The carry trade is a popular leveraged

cross-currency trading strategy that involves borrowing in low-yield currencies

1

According to the 2015 Financial Conduct Authority (FCA) survey on hedge funds, these strategies account

for 16% and 17% of hedge funds in the United Kingdom, respectively. See the survey at https://www.fca.org.uk/

publication/data/hedge-fund-survey.pdf.

412 The Journal of Financial Research