Essays on the dynamics of liquidity networks : a thesis presented in fulfilment of the requirement for the degree of Doctor of Philosophy in Finance at Massey University, Albany, New Zealand
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Date
2023
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Massey University
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Abstract
This dissertation presents three essays on liquidity interrelationships between firms in the Standard and Poor's 500 (S&P500) index using network theory. Liquidity is the ease of trading securities in the financial market. It varies over time and differs significantly across firms. The principal challenge for market participants is the variability and uncertainty in liquidity. In simple terms, market liquidity risk relates to the inability to trade at a fair price with immediacy. Many studies investigate liquidity co-movement of assets and the associated risk. However, almost no empirical work has been devoted to investigating the possibility of liquidity interrelationship through a liquidity network.
In the first essay, I investigate if a liquidity network among 1,174 firms included in the S&P500 exists using 30 years of data, employing a lead-lag liquidity network method to analyse liquidity interrelationships beyond contemporaneous spillover effects. I find an intertemporal liquidity network where 84% of the firms exhibit statistically significant connectivity in at least one direction during the sample period. The degree and manner of liquidity communication vary across the firms and are dynamic over time. Furthermore, I show that individual firms' characteristics, such as the level and change in liquidity, firm size, and return volatility, can explain their network structure. The outcome emphasizes the fragility of the liquidity system through the firms' connectivity which can be a new factor to consider when evaluating firms' expected rate of return.
The second essay explores the relationship between the firm-level liquidity shock transmission through the liquidity network and the role that firm-size plays in the transmission process. I find that the transmission of the liquidity shock depends on the firm size. The greater intensity shocks influence the transmission more through larger firms than small firms. I also find that with one unit increase in the size differences between firms, the odds of firms not being connected in the network increases by 2.5%, suggesting similar-size firms tend to have more connectivity. Furthermore, looking at size-based portfolios, I find that although all the portfolios transmit shock significantly to one another, their explanatory power varies. Most portfolios tend to send out more shocks to the next largest quantiles. The outcome overall suggests that diversification against liquidity shock transmission is possible by including different firm sizes.
Finally, I investigate the impact of the COVID-19 pandemic on liquidity interlinkages of U.S. industry groups. I document that sectors differ in their liquidity interactions during the pre-COVID period, with some sectors more interlinked than others. I also document that the crisis induced by COVID-19 had a significant effect on the liquidity network, with virtually all sectors becoming more interconnected relative to the pre-COVID period. The effect varies across industries, with the real estate sector being the most affected and telecommunication services the least. Overall, due to higher interconnectedness, liquidity risk became harder to diversify.
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Liquidity (Economics), Stock exchanges, Business enterprises, COVID-19 Pandemic, 2020, Economic aspects, United States