Market Liquidity and Ambiguity: The Certification Role of Corporate Governance

• Author: Emre Kuvvet,Christine X. Jiang,Jang‐Chul Kim
• DOI: http://doi.org/10.1111/fire.12051
• Published date: 01 November 2014
• Date: 01 November 2014

The Financial Review 49 (2014) 643–668

Market Liquidity and Ambiguity: The

Certification Role of Corporate Governance

Christine X. Jiang

University of Memphis

Jang-Chul Kim

Northern Kentucky University

Emre Kuvvet∗

Nova Southeastern University

Abstract

Weinvestigate how firm-specific certification practices through corporate governancecan

reduce perceived ambiguity and thus enhance liquidity of a firm in the stock market. We show

that better corporate governance helps reduce ambiguity.In addition, a reduction in ambiguity

is significantly related to higher liquidity of firms. Our results are robust to alternative model

specifications and measures of ambiguity, and remain statistically significantafter controlling

for other known determinants of ambiguity and liquidity. Our results shed light on how

ambiguity can be moderated through firm-level certification practices and on the channel

through which a moderation of ambiguity affects shareholder wealth.

Keywords: ambiguity, uncertainty, corporate governance, spreads, liquidity

JEL Classifications: G10, G34

∗Corresponding author: Finance Department, 3301 College Avenue, H. Wayne Huizenga School of

Business and Entrepreneurship, Nova Southeastern University,Fort Lauderdale-Davie, FL 33314; Phone:

(954) 262-5013; Fax: (954) 262-3974; E-mail: ekuvvet@nova.edu.

We would like to thank Bonnie F. VanNess (the editor), two anonymous referees, the participants at the

2012 FMA annual conference, Thomas Boulton, Michael Pagano, Pankaj Jain, and Thomas McInish for

their comments and suggestions. All errors are our own.

C2014 The Eastern Finance Association 643

644 C. X. Jiang et al./The Financial Review 49 (2014) 643–668

1. Introduction

This paper studies how firm-specific certification practices through corporate

governance can reduce perceived ambiguity and thus enhance liquidity of a firm in

the stock market. Ambiguity (or uncertainty) is defined as a situation in which both

the outcome and its distributions are unknown. This definition corresponds to what

Knight (1921) would refer to as uncertainty.1An important development of recent

research in finance contends that uncertainty, in addition to risk (when outcome

is unknown but the distribution of its outcomes is known) should matter for the

formation of asset prices and other corporate decisions.2

Easley and O’Hara (2010) posit that changing specific features of the microstruc-

ture and certification could potentially reduce perceived ambiguity and increase

participation by both investors and issuers.3In their model, sophisticated traders

are viewed as expected utility maximizers with rational expectations, while unso-

phisticated traders (ambiguity-averse traders) are viewed as rational traders facing

ambiguity about the payoffs to participating in the market. Theoretically, they show

how designing markets to reduce ambiguity can benefit investors through greater

liquidity.4Specifically, they suggest that changes to trading practices, trading rules,

and market design can eliminate worst-case distributions of returns.5

In contrast to the cited studies that focus on differences in ambiguity due to

legal and regulatory environments, our study focuses on differences in ambiguity

that can be attributable to firm-level certification. This important dimension has not

previously been studied in the literature and is the primary contribution of the current

1Knight (1921, p. 11) suggests that “Uncertainty must be taken in a sense radically distinct from the

familiar notion of risk, from which it has never been properly separated. The term ‘risk,’ as loosely used

in everyday speech and in economic discussion, really covers two things which, functionally at least, in

their causal relations to the phenomena of economic organization, are categorically different.The essential

fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is

something distinctly not of this character; and there are far-reaching and crucial differences in the bearings

of the phenomenon depending on which of the two is really present and operating. It will appear that a

measurable uncertainty, or ‘risk’ proper,as we shall use the term, is so far different from an immeasurable

one that it is not in effect an uncertainty at all. Weshall accordingly restrict the term ‘uncertainty’ to cases

of the nonquantitative type.”

2Ellsberg(1961) shows risk-averse individuals show preferences that distinguish between risk (with known

probabilities) and ambiguity (with unknown probabilities).

3Uncertainty and ambiguity are interchangeably used in the literature and throughout the paper.

4Ambiguity-averse investorsdo not act as if there is a single distribution of payoffs to assets; instead they

act as if there is set of distributions, all of which are possible, and do not have a prior over this set of

distributions. These traders are greatly influenced by the worst possible distribution of any portfolio that

they contemplate. These cause ambiguity-averse traders not to participate when the ambiguity in a market

is large (Easley and O’Hara, 2010, pp. 1817–1818).

5Microstructure features such as listing requirements, clearing and settlement protocols, trade monitoring,

best execution requirements, trading halts, and circuit breaker rules can be modified as a means to reduce

ambiguity and increase market participation.