Market Liquidity and Ambiguity: The Certification Role of Corporate Governance

Published date01 November 2014
Date01 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
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:
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.
C2014 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.

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