Liquidity in Up and Down Markets for Asset Pricing: Evidence from the Taiwan Stock Market

• Published date: 01 October 2016
• Date: 01 October 2016
• Author: Yi‐Cheng Shih,Xuan‐Qi Su
• DOI: http://doi.org/10.1111/ajfs.12150

Liquidity in Up and Down Markets for Asset

Pricing: Evidence from the Taiwan Stock

Market

Yi-Cheng Shih*

Department of Finance and Cooperative Management, National Taipei University

Xuan-Qi Su

Department of Finance, National Kaohsiung First University of Science and Technology

Received 19 April 2016; Accepted 21 August 2016

Abstract

Using a sample of stocks listed on the Taiwan Stock Exchange during 1991–2014, this study

investigates the liquidity in up and down markets, which is important for understanding asset

pricing. Firm-level original Amihud, Journal of Financial Markets, 5, 2002, 31. illiquidity is

decomposed into two half-Amihud measures for up- and down-market days. First, we show

that the ability of the down-market liquidity level to explain the cross-section of returns sub-

sumes the up-market liquidity level. Second, only loadings on systematic down-market liq-

uidity factors are significantly priced. Third, a liquidity risk factor constructed by the down-

market component, rather than the up-market component significantly explains the time-ser-

ies and cross-sectional variation in returns sorted by firm size, suggesting that the liquidity

risk factor associated with down-market days performs better in capturing the flight-to-

liquidity. Overall, the findings support the view that the liquidity in down markets plays a

more important role in asset pricing than the liquidity in up markets.

Keywords Down markets; Asset pricing; Liquidity premium; Liquidity risk premium; Flight-

to-liquidity

JEL Classification: G12,G14

1. Introduction

For at least the last three decades, a number of studies have documented that the

firm-specific liquidity characteristic (the liquidity level) and market-wide liquidity

as a systematic risk factor (the liquidity risk) play an important roles in explaining

*Corresponding author: Yi-Cheng Shih, Department of Finance and Cooperative Manage-

ment, College of Business, National Taipei University, 151, University Road, San-shia District,

New Taipei City 237-41, Taiwan. Tel: +886-2-8674-1111 ext.66869, Fax: +886-2-8671-5905,

email: ycshih@mail.ntpu.edu.tw

Asia-Pacific Journal of Financial Studies (2016) 45, 729–754 doi:10.1111/ajfs.12150

©2016 Korean Securities Association 729

the cross-section of asset returns.

1

However, the importance of differences in liquid-

ity between up and down markets for asset pricing is only recently beginning to

receive attention. For example, theoretical models proposed by Anshuman and Vis-

wanathan (2006), Garleanu and Pedersen (2007), and Brunnermeier and Pedersen

(2009) suggest that liquidity in up and down markets behaves differently because of

liquidity shocks, tighter risk management by institutions, and margin-induced price

spirals. Consistent with these theoretical predictions, Hameed et al. (2010) indicate

that large negative market returns have a stronger impact on changes in a firm’s

bid-ask spread than positive market returns.

To extend this literature, this study uses a sample of stocks listed on the Taiwan

Stock Exchange (TWSE), the world’s 12th largest financial market, to investigate

the relative importance of liquidity in up and down markets for various tasks of

asset pricing, including: (i) a test of the liquidity premium, that is, the asymmetric

effect of the firm-specific liquidity characteristic (the liquidity level) on expected

returns; (ii) a test of the liquidity risk premium, that is, the asymmetri c effect of

exposure to innovations in market-wide liquidity (the liquidity risk) on expected

returns; and (iii) a test of the ability to capture the flight-to-quality/liquidity, that

is, the asymmetric effect of unexpected market-wide liquidity on stock returns that

varies across stocks sorted by firm size or liquidity level.

The literature has proposed potential supply-side and demand-side explanations

to indicate that market participants may be more concerned about liquidity during

a period of price declines than during a period of price increases, which implies

that the liquidity in down markets may be more informative for asset pricing than

the liquidity in up markets. In terms of a supply-side explanation, when stock

prices considerably decline, the financial intermediaries (e.g. market makers) are hit

by their margin constraints and are compelled to liquidate. Such funding con-

straints induce an illiquidity spiral and further restrict the market makers from pro-

viding market liquidity (Brunnermeier and Pedersen, 2009). Brennan et al. (2012)

argue that investors who seek to trade in such market conditions will face relatively

worse terms for their sell orders than their buy orders and find that the expected

return premium for illiquidity is affected more by sell-side illiquidity than buy-side

illiquidity. Chordia et al. (2001) suggest that down markets tend to be characte rized

by frenzied selling as compared with steady buying in up markets. As a result, it

can be more difficult for market makers to adjust inventories in a falling market

than a rising market, which, in turn, implies that inventory accumulation become s

more important during market downturns. Evidently, Chordia et al. find that there

1

See, for example: Amihud and Mendelson (1986); Brennan and Subrahmanyam (1996); Eles-

warapu (1997); Brennan et al. (1998); Chalmers and Kadlec (1998); Datar et al. (1998); Fiori

(2000); Amihud (2002); P

astor and Stambaugh (2003); Acharya and Pedersen (2005); Liu

(2006); Sadka (2006); Chordia et al. (2009); Goyenko et al. (2009); Chang et al. (2010); Lou

and Sadka (2011); Lee (2011); Brennan et al. (2012, 2013); Cao and Petrasek (2014); and

Amihud et al. (2015).

Y.-C. Shih and X.-Q. Su

730 ©2016 Korean Securities Association