Liquileaks

Abstract

A security’s liquidity properties have been studied in terms of mean and variance: liquidity level and liquidity risk, respectively. This paper explores tail events, liquidity disaster risk. Liquidity might not be a worry to investors in normal market conditions, but it does become a first-order concern in case the security not only hits an illiquid state, but is also trapped in it so that waiting a day will not restore liquidity. Empirically, such events, referred to as liquidity leaks or liquileaks, can be characterized with a Markov regime-switching model that alternates between a liquid and an illiquid state. Liquileak risk is naturally defined as the probability of finding the security in the illiquid state for more than a week. This probability is estimated based on an unbalanced sample of 2147 stocks from 1963 through 2008. Standard Fama-MacBeth regressions show that a one standard deviation increase in liquileak probability commands an annual premium of 1.33%. This premium has increased over time.

JEL Classification: G12