Flight-to-Liquidity and Global Equity Returns

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1 Fligh-o-Liquidiy and Global Equiy Reurns Ruslan Goyenko and Sergei Sarkissian * Firs draf: November 2007 This draf: May 2008 * The auhors are from he Faculy of Managemen, McGill Universiy, Monreal, QC H3A1G5, Canada. Goyenko maybe reached a and Sarkissian maybe reached a We are graeful o Sam Henkel for providing inernaional sock liquidiy daa. The auhors acknowledge financial suppor from IFM2 and SSHRC. Sarkissian also hanks he suppor of he Desmarais Faculy Scholarship.

2 Fligh-o-Liquidiy and Global Equiy Reurns ABSTRACT Invesmen pracice and academic lieraure documen a grea degree of ineracion beween sock markes around he world and mos liquid and safes asses such as he US Treasury bonds. Using daa from 46 markes, we examine he join impac of he fligh-o-liquidiy and fligh-oqualiy on global asse valuaion. Our proxy for he fligh-o-liquidiy/qualiy is he illiquidiy of US shor-erm Treasury bonds. We find ha i is a leading indicaor of he sock marke illiquidiy, and ha i is also a srong predicor of fuure equiy reurns in boh developed and emerging markes. This predicive relaion remains inac afer conrolling for oher global and local variables, including he lagged US erm spread, dividend yields, equiy marke reurns, as well as global and local sock marke illiquidiy. Subsequen ess reveal ha he bond illiquidiy is significanly correlaed wih conemporaneous sock marke reurns, and ha i is a priced facor even in he presence of oher convenional risk facors, such as he world sock marke reurn, exchange rae, and sock marke illiquidiy. Our resuls indicae ha he fligh-oliquidiy/qualiy risk is an imporan deerminan of reurns in global equiy markes. JEL Classificaion: G12; G15 1

3 1. Inroducion The exising lieraure generally agrees ha sock and bond markes are inerlinked, alhough is economic reasons are no fully undersood. 1 I has also been shown ha hese markes are inegraed via illiquidiy. Chordia, Sarkar, and Subrahmanyam (2005), Goyenko (2006), Goyenko and Ukhov (2007), and Baele, Bekaer, and Inghelbrech (2007) find ha illiquidiy has a crossmarke effec and ha common facors drive illiquidiy and volailiy in sock and bond markes. In his paper, we develop and es an inernaional asse pricing model wih global US Treasury bonds based illiquidiy facor. In our framework, we consider i as a viable proxy for a join fligh-o-liquidiy and fligh-o-qualiy risk around he world. I is well known ha in marke downurns, invesors chase safes and mos liquid securiies such as US Treasures which improves is liquidiy (see Longsaff, 2004). For insance, on he afermah of he LTCM crisis in 1998, he Financial Times wroe: LTCM was heavily invesed in he Russian marke, mos of is exposure was in he US, Europe and Japan, in markes abou as far removed from Indonesian bonds or Brazilian socks as you can ge. Ye is balance shee was wiped ou any reducion in US ineres raes would probably, in iself, no be enough o sop he global fligh o qualiy. 2 This means ha he illiquidiy of he world s safes asses changes over ime in response o asse allocaion shifs from and o more risky securiies. 3 As a resul, he more an asse is exposed o he fligh-o-qualiy (or fligh-o-liquidiy), he higher should be is expeced reurn, i.e., invesors should be receiving a premium for no swiching from illiquid socks ino Treasuries. 1 Fleming, Kirby, and Osdiek (1998) find srong volailiy linkages beween sock and bond markes. Scruggs and Glabadanidis (2003) show ha sock bu no bond reurns respond o boh sock and bond reurn shocks. Connolly, Sivers, and Sun (2005) find ha sock marke uncerainy has imporan cross-marke pricing. Li (2002) provides some evidence ha sock-bond correlaions are deermined primarily by uncerainy abou expeced inflaion. However, Shiller, and Belrai (1992), Campbell and Ammer (1993) and Baele, Bekaer, and Inghelbrech (2007) conclude ha he exising levels of co-movemen canno be jusified by economic fundamenals. 2 Liquidiy crunch hreaens, Financial Times, London (UK): Sep 28, 1998, pg The allocaion of funds o or from equiy markes is no limied o he imes of financial crises. Goezmann and Massa (2002) find ha invesors move funds in and ou of he equiy marke in response o daily marke news and changes in risk. 2

4 Very few sudies accoun for ineres rae based risk facors in general o price equiy reurns. Chen, Roll and Ross (1986) find ha defaul and erm spreads are priced in he sock marke. Scruggs (1998) shows ha bond reurns are imporan for explaining he ineremporal relaion beween expeced marke reurn and risk. Ferson and Harvey (1993) use an ad-hoc se of global risk facors ha includes US bond and Treasury bill reurns and examine equiy pricing across counries. 4 Furher, numerous sudies, alhough focusing on he sock marke illiquidiy only, show is significan impac on he ime-series and cross-secion of expeced sock reurns in he US. 5 In inernaional seing, he role of liquidiy is less precise largely due o he difficuly of consrucing sock-based liquidiy measures for differen counries. Predicably, few sudies in his area yield somewha conradicing resuls. For insance, Bekaer, Harvey, and Lundblad (2007) find ha models wih local liquidiy facors ouperform sandard CAPM in emerging markes. Lee (2006) shows however ha global liquidiy risk is priced and ha he U.S. marke liquidiy is he main driver of his risk. We sudy he imporance of fligh-o-liquidiy/qualiy for global equiy reurns using daa from 46 counries over he 30 year period from 1977 o We sar wih he analysis of he relaion beween he US Treasury bond marke illiquidiy and sock marke illiquidiy around he world. Our proxy for he bond illiquidiy is he average percenage bid-ask spread of off-he-run US Treasury bonds wih mauriies of up o one year. Goyenko, Subrahmanyam, and Ukhov (2007) demonsrae ha he illiquidiy of shor-erm off-he-run issues is he main deerminan of illiquidiy premium in he US Treasury bond marke. Our proxy for he sock marke illiquidiy in each counry is he value-weighed proporion of daily zero reurns in a given monh as in Bekaer, Harvey, and Lundblad (2007) and Lee (2006). The vecor-auoregression analysis shows ha bond illiquidiy predics sock marke illiquidiy, boh a he counry level and worldwide, bu 4 Mos of he papers on inernaional equiy reurns effecively assume segmenaion of he sock and bond markes, and herefore price equiy reurns using solely global and/or local sock marke based risk facors (e.g., see Harvey, 1991; Bekaer and Harvey, 1995; Karolyi and Sulz, 1996; De Sanis and Gerard, 1997; and Carrieri e al., 2006). Dumas and Solnik (1995), De Sanis and Gerard (1998) and some oher sudies also accoun for currency risk. 5 See Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996), Amihud (2002), Pasor and Sambaugh (2003), and Acharya and Pedrsen (2005) among ohers. 3

5 no vice-versa. This is consisen wih fligh-o-liquidiy/qualiy episodes occurring no only in he US (see Goyenko and Ukhov, 2007) bu also in oher counries. Furhermore, bond illiquidiy reains is predicive power for sock marke illiquidiy in he presence of world and local equiy marke reurns and volailiies. We also observe ha, unlike sock marke illiquidiy, global equiy marke volailiy and he US federal funds rae predic he variaion in he bond illiquidiy. Nex, we run regressions of sock reurns on he lagged bond illiquidiy and oher lagged variables o deermine he imporance of bond illiquidiy in predicing global asse reurns. The ess show ha he slope on he bond illiquidiy is significan and negaive across boh developed and emerging markes, implying ha he curren increase in he bid-ask spread in he US Treasury marke decreases nex period sock marke reurns around he world. This resul is robus o he inclusion of oher sandard local and global predicors of counries equiy marke reurns such as he lagged local marke reurns, dividend yields, he US erm spread, as well as local and world sock marke liquidiy measures. The negaive effec of bond illiquidiy on fuure equiy reurns can be explained as follows. Goyenko, Subrahmanyam and Ukhov (2007) show ha bond spreads increase under moneary policy ighening, which ofen reflecs he worsening of economic condiions. In hese condiions, when boh sock and bond markes are down, Treasuries decrease less in value han socks and he fligh-o-liquidiy/qualiy from he sock marke occurs. Bond spreads, reacing firs o he increase in real raes, forecas increase in sock marke illiquidiy (see Goyenko and Ukhov, 2007). An increase in sock marke illiquidiy has a negaive impac on conemporaneous equiy reurns (e.g., see Amihud, 2002). Therefore, an increase in he bond illiquidiy, which predics increase in illiquidiy in he sock marke, should also have a negaive effec on expeced sock reurns. Third, we examine he asse pricing implicaions of he fligh-o-liquidiy/qualiy risk by considering wo nesed models of full marke inegraion and wo nesed models of parial marke inegraion. The main full inegraion model includes he world marke risk, he bond illiquidiy risk, as well as he exchange rae risk facors. The main parial inegraion model, besides he 4

6 world marke and bond illiquidiy risk, also accouns for he local marke variance and sock illiquidiy risk. We conduc our esimaion in wo seps. In he firs sep, using he mulivariae GARCH (1,1) mehodology, for each counry we compue is condiional reurn variance and he se of condiional covariances beween local marke equiy reurns and each of he risk facors presen in a specific asse pricing model. In he second sep, we use GMM and esimae prices of risk on he enire sample of counries as well as separaely for he sub-samples of developed and emerging markes. We also use condiional esimaes o compue condiional bond illiquidiy beas for each counry and relae hem o he se of counry-level macroeconomic and financial variables. The resuls of our asse pricing ess show a negaive and significan price of he bond illiquidiy risk in he presence of all oher global and local facors. This holds across he whole sample of counries as well as for he groups of developed and emerging markes. The price of bond illiquidiy risk is negaive because, in conras o sock marke illiquidiy, he covariance beween he bond illiquidiy and reurns is negaive on average. An increase in sock marke illiquidiy increases expeced equiy reurns (Amihud, 2002) and causes cash ouflow ino he bond marke (Agnew and Balduzz 2007). This cash ouflow decreases bond illiquidiy, hus producing a negaive covariance beween bond illiquidiy and sock reurns. This implies ha he higher is he counry s sock marke sensiiviy o he increase in he percenage bid-ask spread of US Treasury bonds, he higher is a propensiy of fligh-o-liquidiy and he higher is is expeced reurn. The poin esimaes of he price of he bond illiquidiy risk are beween 0.25 and 0.60 for he enire sample of counries depending on model specificaion. In economic erms, his ranslaes ino an average annual premium aribued o he fligh-o-liquidiy risk o be beween 0.35% and 0.75%. I is comparable in magniude o he sock illiquidiy premium of 1.1% per annum repored by Acharya and Pedersen (2005) in he US equiy marke. The esimaes of he bond illiquidiy price of risk are larger in magniude in emerging markes, as one would expec given more occurrences of fligh-o-liquidiy/qualiy from hose counries. The only oher 5

7 consisenly priced facor, no surprisingly, is he world marke porfolio reurn, which yields he price of risk beween 2.50 and This esimaion range is in line wih ha from many oher previous sudies. The res of he paper is organized as follows. Secion 2 highlighs he economic inuiion for he exisence of he Treasury bond illiquidiy premium in sock markes around he world. Secion 3 describes he daa, and offers iniial analysis on he imporance of bond illiquidiy. In paricular, we analyze he relaion beween bond illiquidiy and global and local sock marke illiquidiy and examine predicive regressions of sock marke reurns on he lagged values of bond illiquidiy and oher variables. In Secion 4, we develop our condiional asse pricing mehodology. Secion 5 presens resuls from he asse pricing ess. In his secion, we also relae our esimaes of he fligh-o-liquidiy risk o he se of counry-level macroeconomic and financial variables. Secion 6 concludes. 2. Economic Moivaion There are several reasons o expec he exisence of he Treasury bonds illiquidiy premium in he inernaional equiy markes. Firs, US Treasury securiies consiue one of he larges markes and are raded around-he-clock in he hree larges financial ceners of Tokyo, London, and New York. The daily rading volume in he secondary marke for Treasuries averaged $125 billion in 1995 compared o $ billion in he end of Given his marke srucure, he Treasury illiquidiy can immediaely reac o economic announcemens and oher developmens around he world. Second, invesors ouside of he US hold large sakes in US Treasuries. In paricular, foreign official accouns held $1.3 rillion of Treasury securiies a he end of 2005, or abou 30 percen of all markeable Treasury securiies ousanding (see Fleming, 2007). In fac, he 6 Source: Federal Reserve Sysem, Treasury Bullein 6

8 holdings of Treasuries by foreigners have increased rapidly during he las decade. A he end of 1996 foreign invesors held close o 28% of all markeable Treasury securiies ousanding bu by he end of 2006 heir holdings reached almos 45%. 7 The evidence shows a very acive rading of Treasury securiies by inernaional invesors. Third, he fligh-o-qualiy and -liquidiy akes place no only domesically bu also inernaionally (e.g., see Longsaff, 2004). Therefore, an illiquidiy shock in he sock marke of he US or worldwide causes fund ouflow from equiy marke ino he US Treasury bond marke. Since he funds flow beween he markes affecs illiquidiy (see Chordia, Sarkar, and Subrahmanyam, 2005; and Goyenko and Ukhov, 2007), i should also impac securiy prices. Indeed, Goezmann and Massa (2002) find ha when invesors move funds in and ou of he equiy marke in response o daily marke news, hese fund flows affec equiy prices. Agnew and Balduzzi (2007) observe ha 401(K) plan paricipans daily rebalancing beween equiies and fixed-income insrumens affec asse prices. Therefore, changes in he bond illiquidiy, which firs reflecs changes in he curren economic environmen, are accompanied by fund flows beween he inernaional sock and he US Treasury bond markes, and herefore mus have an impac on equiy reurns across counries. Finally, noe ha US Treasuries have a comparaive advanage over sovereign deb of oher counries. In paricular, Beber, Brand, and Kavajecz (2007) find ha in general, while rebalancing owards less risky and more liquid asses such as fixed income securiies, invesors care boh abou credi qualiy and liquidiy. However, during economic or sock marke disress hey care he mos abou liquidiy. US Treasuries, being of he highes credi qualiy, are also considered as he mos liquid among governmen deb insrumens of oher counries. Aroundhe-clock availabiliy and around-he-world rading makes hem he source of inernaional demand for liquidiy. Given many plausible reasons for a non-rivial impac of US Treasury bond illiquidiy on equiy markes around he world, our nex goal is o deermine he expeced signs of his effec on 7 Source: Federal Reserve Sysem, Treasury Bullein. 7

9 sock reurns in boh predicive and conemporaneous relaions. Goyenko, Subrahmanyam, and Ukhov (2007) argue ha moneary policy is one of he main deerminans of bond illiquidiy flucuaions. They demonsrae ha bond illiquidiy increases conemporaneously and wih a lag in response o moneary policy conracion. Thus, bond illiquidiy can be viewed as a financial variable which direcly capures informaion abou changes in he U.S. moneary policy. Several sudies esablish a link beween changes in moneary policy and sock reurns. Paelis (1997) repors ha igher moneary condiions predic low excess reurns in he sock marke. He finds ha moneary policy variables affec he variance of he dividend growh he mos and argues ha igher moneary condiions lead o reduced and coslier bank-loan supply, hereby decreasing fuure cash flows. Thorbecke (1997) and, more recenly, Bernarke and Kuner (2005) demonsrae ha moneary policy conracion has also large and saisically significan negaive conemporaneous effec on sock values. These auhors suggess ha moneary policy affecs firms access o credi and herefore again impacs cash flows. In sum, he macroeconomic lieraure finds negaive predicive and negaive conemporaneous effecs of moneary policy ighening on sock values due o reduced curren and subsequen cash flows. Thus, we expec US Treasury bond illiquidiy o have a similar impac on global equiy reurns Daa and Iniial Analysis 3.1. Daa Our daa sample consiss of 46 counries, ou of which 23 are classified as developed and 23 as emerging. The sample covers he 30-year period from January 1977 o December 2006, alhough for many counries he ime series daa sar significanly laer han For each counry, we 8 Empirical finance lieraure documens ha anoher financial variable closely relaed o moneary policy, shor-erm ineres rae, also has negaive predicive and conemporaneous effec on sock prices (e.g., see Breen, Glosen, and Jagannahan (1989), Fama and Schwer (1977), Campbell (1987)). However, Bernarke and Kuner (2005) poin ou ha he reacion of equiy prices o moneary policy is no direcly relaed o policy s impac on he real ineres rae. 8

10 collec monhly local equiy marke reurns in US dollars and dividend yields from Daasream (for developed marke) and IFC Global Indices (for emerging markes). We consruc excess reurns by subracing he one-monh US Treasury bill rae from gross reurns. Following Bekaer, Harvey, and Lundblad (2007) and Lee (2006), our proxy for he sock marke illiquidiy in each counry is he value-weighed proporion of zero daily reurns across all firms in ha counry during a monh. The world sock marke illiquidiy is he value-weighed average of counries aggregae illiquidiy. Our proxy for he fligh-o-liquidiy/qualiy is he US Treasury bond illiquidiy which we compue as he average percenage bid-ask spread of off-he-run US T- bills wih mauriies of up o one year. Once issued, he securiy is considered as on-he-run and he older issues are off-he-run. The quoed bid and ask prices are from CRSP daily Treasury Quoes file. Table 1 shows he number of observaions, means, volailiies, and firs-order auocorrelaions of monhly excess equiy reurns, dividend yields, and he sock liquidiy measure for each counry and for he world marke. The number of observaions corresponds o hose for equiy marke reurns. As expeced, he average monhly reurns and volailiies in emerging markes are higher han hose in developed markes. The auocorrelaion of dividend yield is very high, in excess of 0.90 in all bu five counries. The marke illiquidiy is higher on average in emerging markes han developed. I is also an auocorrelaed variable alhough no as much as he dividend yield. The only counry wih negaive firs-order auocorrelaion in illiquidiy is China Treasury Bond and Sock Marke Illiquidiy We firs invesigae he relaion beween he US Treasury bond illiquidiy and sock marke illiquidiy around he world. Our primary goal here is o deermine wheher here is an illiquidiy linkage beween he markes. For example, funds inflow ino he US Treasuries from he sock marke caused by fligh-o-liquidiy would affec bond illiquidiy (Longsaff, 2004). Fund movemens beween he markes may impac illiquidiy and cause illiquidiy spillover (Goyenko 9

11 and Ukhov, 2007). Subsequenly, if illiquidiy of one marke affecs illiquidiy of he oher marke, i may also forecas illiquidiy premium in he oher marke, i.e. illiquidiy spillover across markes may also lead o he cross-marke spillover of illiquidiy premium. The resuls of his analysis are repored in Table 2. Panel A shows he oucomes from VAR(1) models for he bond illiquidiy, L B, wih eiher he world marke illiquidiy, L w, or he local marke illiquidiy, L i. We observe ha he bond illiquidiy predics boh he world and local sock marke illiquidiy, bu he reverse is no rue. The coefficien on he lagged L B is posiive in boh esimaions and significan a he 10% level for he world marke illiquidiy and 1% level for he local marke illiquidiy. This implies ha he curren increase in he illiquidiy of he US Treasury bond marke leads o an increase in he sock marke illiquidiy nex period globally and across differen counries. Earlier sudies sugges ha reurns and volailiy of reurns are imporan drivers of illiquidiy (see Amihud and Mendelson, 1986; and Benson and Hagerman, 1974). More recen sudies such as Chordia, Roll, and Subrahmanyam (2001), and Chordia, Sarkar, and Subrahmanyam (2005) find ha reurns are imporan deerminans of illiquidiy in he sock marke. Furhermore, Goyenko, Subrahmanyam, and Ukhov (2007) show ha moneary policy affecs bond marke illiquidiy. Moneary policy can also affec sock marke illiquidiy by ighening invenory consrains of marke makers and increasing borrowing coss of rading (e.g., Chordia, Sarkar, and Subrahmanyam, 2005), Therefore, in Panel B of Table 2 we show he esimaes from VAR(1) models involving, besides he bond and sock marke illiquidiy, global and local sock marke excess reurns and volailiies, as well as he changes in he US federal funds rae, FED, and he US erm spread, TERM. As before, we observe a significan and posiive impac of he lagged bond illiquidiy on boh he world (columns one and wo) and local (columns hree and four) sock marke illiquidiy. Furhermore, consisen wih invenory paradigm (e.g., see Ho and Soll, 1983; and O Hara and Oldfield, 1986), we find ha local marke volailiy is an imporan deerminan of local sock marke illiquidiy: he slope 10

12 coefficien on volailiy is posiive and significan a he 1% level. Finally, shifs in he US federal funds rae seem o forecas local sock marke illiquidiy bu no he global sock illiquidiy. Thus, while he sock marke illiquidiy is prediced by he bond illiquidiy, he variables ha can poenially predic bond illiquidiy are no relaed o sock marke illiquidiy. Table 3 repors he VAR(1) resuls for he bond illiquidiy. As in he case of sock marke illiquidiy, we consider he world sock marke reurn and volailiy, he changes in he US federal funds rae, and he US erm spread. We also use he world dividend yield, DY w, as an alernaive o he erm spread o proxy general marke condiions. For consisency, in all esimaions, we reain he lagged world sock marke illiquidiy measure. Regression (1) shows ha he slope on he lagged world marke volailiy is negaive and significan a he 10% level. However, afer accouning for changes in he federal funds rae and eiher he erm spread or he world dividend yield, in Regressions (2) and (3) respecively, he coefficien on he lagged volailiy losses is significance. Insead, we find a posiive and significan a he 1% level coefficien on he federal funds rae in boh of hese esimaions. Therefore, consisen wih he previous lieraure, moneary policy ighening increases illiquidiy in he bond marke. In Regression (3), we also observe a significan coefficien on he world dividend yield. However, aking ino accoun an exreme persisency of he dividend yield (he auocorrelaion is 0.99), we rerun he VAR(1) sysem of Regression (3) on he subsample in Regression (4). We observe ha he world dividend yield compleely looses is significance. In his sub-sample, he lagged changes in he federal funds rae are sill significan a he 5% level. In addiion, he world marke volailiy regains and even improves is significance compared o Regressions (2) and (3). Thus, i appears ha boh he US moneary policy and global sock marke volailiy have an impac on he illiquidiy of Treasury bond marke. However, sock marke illiquidiy does no affec bond illiquidiy. The effec of volailiy on bond illiquidiy is consisen wih he fligh-o-liquidiy or fligh-o-qualiy effecs. An increase in he sock marke volailiy causes funds inflow ino he bond marke and improves bond liquidiy. 11

13 In sum, bond illiquidiy has predicive power over sock illiquidiy bu no vice versa. An increase in bond illiquidiy, which is associaed wih moneary policy ighening in he US, predics an increase in sock illiquidiy around he world. In addiion, sock marke affecs bond illiquidiy via volailiy. An increase in sock marke volailiy, which is a characerizaion of worsening of illiquidiy condiions, causes fligh-o-liquidiy and decreases bond illiquidiy Predicive Regressions Given srong predicive power of bond illiquidiy for he world and local sock marke illiquidiy, we now examine wheher i has similar predicive abiliy for he world and local equiy marke reurns. If bond illiquidiy predics sock illiquidiy i migh as well predic sock marke illiquidiy premium. Noe ha bond illiquidiy, similar o sock marke illiquidiy, is a persisen variable. Ferson, Sarkissian, and Simin (2003) warn agains using sandard saisical inference in regression of sock reurns on lagged insrumens when regressors are auocorrelaed. Therefore, o preclude any concerns for spurious regression bias, in he subsequen analysis, as in he sudies on sock marke illiquidiy (e.g., see Pasor and Sambaugh, 2003; and Acharya and Pedersen, 2005), we use he AR(2) residuals as a measure of bond illiquidiy raher han he level. Table 4 presens several specificaions of predicive regressions. We esimae all models for he enire sample of daa as well as for he sub-samples of 23 developed and 23 emerging markes. In all models, we also conrol for counry fixed effecs and use he Newey-Wes robus sandard errors wih 6 lags. Regression 1 includes only bond illiquidiy as an independen variable. We observe ha he slope coefficien has negaive sign and i is significan a he 1% level for all counry samples. Regressions 2 and 3, besides bond illiquidiy, include he lagged local marke reurn as well as eiher he world or he local sock marke illiquidiy, respecively. In spie of hese addiions, he slope coefficien on bond illiquidiy is similar o ha in Regression 1: i is negaive and sill significan a he 1% level. The lagged sock marke reurn is also significan bu posiive across all esimaions indicaing he exisence of shor-erm reurn predicabiliy. However, here is no consisen evidence of he imporance of he lagged sock 12

14 marke illiquidiy for expeced equiy reurns. When he lagged world marke illiquidiy is used as a proxy for sock marke illiquidiy, is slope coefficien is negaive and significan only on he enire sample of counries bu no separaely for he developed and emerging marke groups. When he local marke illiquidiy is used as a predicive variable, is slope is significanly negaive only for developed counries. 9 Finally, Regressions 4 and 5 conrol for some of he usual variables ha are believed o predic sock reurns, such as local dividend yields and he US erm spread. The coefficien on bond illiquidiy reains is negaive sign and high significance across all esimaions. The lagged local marke reurn also comes up prominenly wih a posiive sign and srong saisical significance a he 5% level in all esimaions bu one for emerging markes in Regression 4. The sock marke illiquidiy again shows no consisen oucome across counries, boh in erms of sign and saisical significance. The lagged local dividend yields and erm spread have he expeced posiive sign, and are significan a he 5% or 10% levels. However, he saisical imporance of he dividend yield and erm spread predicabiliy mus be aken wih a cauion given a highly auocorrelaed naure of hese variables. To summarize, he Table 4 shows ha our proxy for he fligh-o-liquidiy/qualiy has a srong predicive abiliy for sock reurns around he world. The negaive effec of bond illiquidiy on fuure equiy reurns has he following inuiion. An increase in bond spreads can be aribued o moneary policy ighening which reflecs he worsening of economic condiions when boh sock and bond markes are down (see Goyenko, Subrahmanyam, and Ukhov, 2007). Under hese condiions, Treasury bonds decrease less in value han socks and he fligh-o-liquidiy/qualiy from he sock marke akes places. As Goyenko and Ukhov (2007) show, bond illiquidiy, by immediaely reacing o changes in moneary policy, is able o forecas changes in he sock marke illiquidiy. Unexpeced increase in sock marke illiquidiy has a negaive impac on conemporaneous equiy reurns (Amihud, 2002). Therefore, an increase in he bond illiquidiy, 9 To es for he consisency of our measure of sock marke liquidiy wih ha used in oher recen sudies, we have also regressed local sock marke reurns on he lagged reurns and lagged sock marke liquidiy using he same counry and ime period samples as in Bekaer, Harvey, and Lundblad (2007). The resuls of his esimaion, which are available on reques, are similar o hose in heir sudy. 13

15 which predics an increase in sock illiquidiy (and subsequen fligh-o-liquidiy) also has a negaive effec on expeced sock reurns. Our resuls demonsrae ha changes in bond illiquidiy have global impac on equiy prices. 4. Condiional Mehodology 4.1. General framework In his secion, we es asse pricing models of global equiy reurns under full and parial marke inegraion all of which accoun for he fligh-o-liquidiy/qualiy risk. 10 We assume consan prices of all risk facors. If counry i is inegraed wih he world and purchasing power pariy holds across counries, hen is expeced reurn a ime given he informaion a ime -1 is deermined based on is condiional covariance wih he reurn on he world marke porfolio, and he bond illiquidiy facor, namely: ( r ) = Cov ( r, r ) λ Cov ( r L ) E 1 w 1 w, + LB 1, B, where λ, (1) λ w is he price of he world marke risk and λ LB is he price of he fligh-oliquidiy/qualiy risk. However, if here are deviaions in he purchasing power pariy across counries (see Dumas and Solnik, 1995), hen he exchange rae risk maybe a priced facor oo, and equaion (1) mus be exended o accommodae is impac as follows: ( r ) = Cov ( r, r ) + λ Cov ( r, L ) λ Cov ( r r ) E 1 w 1 w, LB 1 B, + c 1, c, λ, (2) where r c, is he reurn on he currency baske deposi a ime and λ c is he price of currency risk. 10 Noe ha he fligh-o-liquidiy/qualiy risk is a global risk facor and herefore canno be presen in fully segmened markes. 14

16 If counry i is parially inegraed wih he world (see Errunza and Losq, 1985), hen is expeced reurn a ime given he informaion a ime -1 is also deermined by he variance of is own marke reurn, ha is, ( r ) = Cov ( r, r ) + λ Cov ( r, L ) λ ( r ) E 1 w 1 w, LB 1 B, + i Var 1 λ, (3) where λ i is he price of counry i risk. Afer accouning for he exchange rae risk, equaion (3) is exended o: E ( r ) = λ Cov ( r, r ) + λ Cov ( r, L ) + λ Cov ( r, r ) λ ( r ) 1 w 1 w, LB 1 B, c 1 c, + i Var 1. (4) To es wheher he fligh-o-liquidiy/qualiy risk is priced in global markes we need o deermine wheher here exiss a risk premium associaed wih he bond illiquidiy. Recen research shows ha sock marke illiquidiy is an imporan facor for US sock reurns (e.g., see Amihud, 2002, Pasor and Sambaugh, 2003, Acharya and Pedersen, 2005). There is some evidence ha sock marke illiquidiy is also imporan in global markes (e.g., Bekaer, Harvey, and Lundblad, 2007; Lee, 2006). To conrol for sock marke illiquidiy, we furher exend he parial inegraion model (4) o accommodae for he second counry-specific facor, is marke illiquidiy. This yields he following model, E 1 ( ri, ) = λw Cov 1( ri,, rw, ) + λlb Cov 1( ri,, LB, ) + λc Cov 1( ri,, rc, ) + λ Var ( r ) + λ Cov ( r, L ) i 1 Li 1 where λ Li is he price of equiy marke illiquidiy risk in counry i. +, (5) 4.2. Pracical Consideraions Evaluaing models from (1) hrough (5) joinly across 46 counries in a condiional framework wih unknown condiional variances and covariances is pracically impossible. Therefore, we esimae asse pricing models in wo seps. In he firs sep, we esimae he condiional variances of equiy marke reurns and heir covariances wih all risk facors depending on he model specificaion. We obain hese esimaes separaely for each counry wihin a mulivariae 15

17 GARCH (1,1) seing ha includes reurn and risk facor dynamics. Here we follow Harvey (1991), Ferson and Harvey (1993), and many ohers and model counry equiy reurns and risk facors as linear funcions of global and local informaion variables. Our choice of informaion variables is largely deermined by he resuls in Tables 2, 3, and 4. For local (world) marke reurn, we use he lag of he following variables: local (world) marke reurn, local (world) dividend yield, he US erm spread, he bond illiquidiy, as well as he local (world) sock marke illiquidiy. The change in he exchange rae is prediced by he reurn on he currency baske deposi and he change in he US federal funds rae. In our esimaions, he reurn on he currency baske deposi a ime is compued as he equally weighed average of exchange rae changes wih he US dollar of four global currencies: he Briish Pound, Euro, Japanese Yen, and Swiss Franc. The bond illiquidiy is prediced by he world sock marke volailiy and he changes in he US federal funds rae (see Table 3). Finally, he sock marke illiquidiy is prediced by is own value as well as he marke reurn, volailiy, and bond illiquidiy. More specifically, for example, for he mos compuaionally complicaed model (5) we esimae he following mulivariae GARCH (1,1) sysem for each counry: r = 10 + δ11ri, 1 + δ12dyi, 1 + δ13term 1 + δ14lb, 1 + δ15li, 1 + r δ e (6a) w, = 20 + δ 21rw 1 + δ 22DYw, 1 + δ 23TERM 1 + δ 24LB, 1 + δ 25Lw, 1 + δ e (6b) L B, = 40 + δ 41σ w, 1 + δ 42FED 1 + elb, δ (6c) r c, = 30 + δ31rc, 1 + δ32fed 1 + ec, δ (6d) L = 50 + δ51li, 1 + δ52lb, 1 + δ53ri, 1 + δ54σ 1 + el δ (6e) w, We also esimae sysem (6) for he world marke porfolio. In his case, he sysem is reduced o four equaions: equaions (6b-d) and all local marke variables in equaion (6e) are replaced wih he corresponding world marke characerisics, namely: L w, = 50 + δ51lw, 1 + δ52lb, 1 + δ53rw, 1 + δ54σ w, 1 + elw, δ. (6f) 16

18 In sysem (6a-e), he error erm, e = e, e, e, e, e ] is assumed o be a mulivariae [ w, c, LB, L normal disribuion wih condiional variance-covariance marix H. Marix H has he following srucure: H C' C + A' e e' A B H = ' 1, B where C is a (5x5) upper riangular marix, A, and B are (5x5) diagonal marices. Tha is, we assume ha he curren variance depends only on he lagged condiional variance and lagged squared errors, while he curren covariance depends only on he lagged covariance and lagged cross-produc of errors. To obain he parameer esimaes, we employ he Bernd, Hall, Hall and Hausman (BHHH) opimizaion algorihm. While sysem (6) yields he esimaes of pairwise covariances beween all variables, for each counry we are ineresed only in he condiional covariances beween r i, on he one side and r w,, r,, L B,, and L on he oher. c In he second sep, we use panel GMM and esimae pricing momens across all counries (or counry groups) and he world marke. For example, he momens for model (5) are: ζ ζ w, = r = r i w, Lw w λ Vˆ ar λ λ Ĉov 1 λ Vˆ w Ĉov 1( ri,, rw, ) λlb Ĉov 1( ri,, LB, ) λc Ĉov 1( ri,, rc, ) ( ri, ) λli Ĉov 1( ri,, Li, ) ar 1( rw, ) λlb Ĉov 1( ri,, LB, ) λc Ĉov 1( ri,, rc, ) ( r, L ) 1 w,, (7) where ζ and ζ w, are he error erms of counry i and world marke excess reurn equaions a ime, respecively, while he ha denoes he condiional variances and covariances from he mulivariae GARCH (1,1) esimaion. A his sage, we esimae he following prices of risk [ λ, λ, λ, λ, λ, λ ], i.e., (2N+4) parameers, where N is he number of counries used. To creae he orhogonaliy condiions in an over-idenified, ye parsimonious sysem, we use an insrumen vecor Z which, besides he consan, includes only wo global informaion variables: he lagged reurn on he world marke porfolio and he lagged value of bond illiquidiy, ha is, Z 1 = [ 1, r w, 1, LB, 1 ]. This gives a oal of (3N+3) orhogonaliy condiions in he GMM esimaion. However, in a large esimaion w LB Lw c i Li 17

19 sysem like (7), a small insrumen se may lead o difficulies in convergence. Therefore, he alernaive insrumen se ha we use includes hree addiional variables: he lagged values of he reurn on he currency baske depos world dividend yield, and US erm spread, ha is, al Z 1 = [ 1, r w, 1, LB, 1, re, 1, DYw, 1, TERM 1 ], which yields (6N+6) orhogonaliy condiions. Finally, aking ino accoun a comprehensive sudy of GMM performance in small samples by Andersen and Sørensen (1996), in all our GMM esimaions, we use Barle Kernel, Andrews Bandwidh, and ieraive updaing of boh he weighing marix and coefficiens. 5. Empirical Tess 5.1. Condiional Treasury Bond Illiquidiy Beas We begin wih examining he oucome of our mulivariae GARCH (1,1) esimaions. In paricular, given he esimaes of he condiional variance of he bond illiquidiy, Vˆ ar 1 ( L B, ) he condiional covariance of counry reurns wih he bond illiquidiy, ov ( L ) consruc for each counry i he condiional bond illiquidiy bea as: ( L ) Ĉov ( r, L ) Vˆ ( L ) Bea, 1 r, B,, and Ĉ, we can 1 B, = 1 B, ar 1 B. (8) We plo he ime-series of he condiional bond illiquidiy bea in Figure 1. I shows he beas for developed markes (Plo A) and emerging markes (Plo B). These beas are averaged for each monh across 23 developed and 23 emerging markes, respecively. We can see ha he beas for boh counry groups are highly volaile, especially afer The average condiional bea for developed markes is close o bu below zero, while ha for emerging markes is much more negaive. This resul is consisen wih economic inuiion since he average fligh-oliquidiy risk or he effec of bond illiquidiy on equiy reurns should be more pronounced for emerging markes. The negaive covariance beween sock reurns and bond illiquidiy conrass wih he posiive covariance beween sock reurns and sock marke illiquidiy documened in many oher 18

20 sudies (e.g., Amihud, 2002; Pasor and Sambaugh, 2003; Bekaer, Harvey, and Lundblad, 2007). This effec can be explained as follows. When he sock marke becomes illiquid, funds flow ino more liquid and less risky Treasury bond marke. For example, Longsaff (2004) repors a large liquidiy premium in he US Treasury bonds and finds srong evidence ha his premium, among oher hings, is relaed o changes in flows ino equiy and money marke muual funds. The ouflow of funds from equiy markes leads o improvemens in bond liquidiy and appreciaion in bond prices. Recen sudies also show ha fund ouflows from equiy markes are persisen (see Agnew and Balduzzi 2005), and ha hey affec sock prices (Goezmann and Massa, 2002). Therefore, a posiive illiquidiy shock in he sock marke causes expeced equiy reurns o increase because of increases in boh sock marke illiquidiy and cash ouflow ino he bond marke. Thus, lower bond bid-ask spreads correspond o higher reurns in he sock marke, implying a negaive covariance beween sock reurns and bond illiquidiy. The more negaive is his covariance, he more illiquid is he counry s equiy marke, and so one should expec more cash ouflow from his marke ino liquid Treasury bonds in unfavorable marke condiions. We also analyze cross-secional properies of he bond illiquidiy beas. Figure 2 shows he relaion beween average counry excess reurns and he average condiional beas. We observe ha mos average bond illiquidiy beas are negaive and ha here is a downward rend beween beas and mean reurns. The plo implies ha he lower is he counry s sock marke exposure o he increase in he bid-ask spread of he US Treasury bond (i.e., he increase in he bond illiquidiy) in absolue value, he lower is is expeced reurn. No surprisingly, mos of he poins on he plo wih he larges in magniude bu negaive average condiional bond illiquidiy beas belong o emerging markes. The counries wih close o zero or posiive bond illiquidiy risk maybe regarded as markes which have relaively more liquid sock markes and less exposed o he worldwide fligh-o-liquidiy/qualiy episodes. Given a wide dispersion of bond illiquidiy beas across counries, we explore if here are any counrywide characerisics ha can explain he cross-secional differences in hese beas. Table 5 repors he se of some average counry-level variables. CORR is he average counry s 19

21 equiy marke correlaion wih he world marke porfolio over he enire sample period. Size is he average raio of marke capializaion o GDP from Djankov e al. (2007). LISTINGS is he number of all overseas lisings raded on various world sock exchanges a he end of 1998 from Sarkissian and Schill (2004). We can hink of hese hree variables as marke developmen proxies. PE and RATE are from Daasream and correspond o he average counry s P/E raio and is shor-erm ineres rae over he enire sample period. These wo variables maybe regarded as dynamic indicaors since hey are easily observable over ime a any sampling frequency. FREEDOM is he average index of economic freedom in from he Heriage Foundaion. 11 LAW is he ani-self-dealing index again from Djankov e al. (2007). This las se of counry characerisics can be hough of as an invesor environmen. Table 6 repors he resuls of he regression of average condiional bond illiquidiy beas across counries on various ses of counry characerisics from Table 5. We also show he roo mean squared error for each regression model. In esimaions, he number of foreign lisings and he shor rae are aken wih logs. Regression 1 includes only one regressor, CORR, and i yields posiive and significan resul. This implies ha he higher is he correlaion of he local sock marke wih he world, he lower is is sensiiviy o he fligh-o-qualiy risk. However, when we include he oher wo marke developmen variables, i.e., he SIZE and LISTINGS in Regression 2, CORR passes is sign and significance o he number of overseas lisings. Regression 3 deals wih dynamic indicaors. The P/E raio comes up posiive and weakly significan, while shor-erm rae negaive and significan. Regression 4 shows he regression resuls wih he invesor environmen proxies and we observe a posiive and significan relaion beween economic freedom and he bond illiquidiy bea. However, when we combine marke developmen variables wih dynamic indicaors in Regression 5 and, in addiion, wih invesor environmen proxies in Regression 6, we find ha he only variable ha reains saisical significance a he 5% level and economically meaningful sign is he number of overseas lisings. Thus, i appears ha he more inegraed a counry is wih he world marke in 11 The index can be downloaded from he Foundaion s web sie a hp:// 20

22 erms of he size of is foreign lising aciviy, he less concerns he invesors will have wih ha marke s fligh-o-liquidiy risk Asse Pricing Tes Resuls To furher examine he cross-secional imporance of he bond illiquidiy risk for inernaional equiy marke reurns, we urn our aenion o he resuls of he GMM ess. Noe ha he condiional covariance of counry reurns wih bond illiquidiy is negaive on average. Therefore, if he bond illiquidiy is a sysemaic facor in inernaional equiy markes, i mus have a negaive price of risk. We group our ess based on he degree of inegraion. Table 7 shows he resuls of GMM esimaion for wo full inegraion (FI) models based on equaions (1) and (2) across he enire counry sample as well as separaely for developed and emerging markes. The esimaion period is for developed markes and for emerging. The condiional esimaes of he variances and covariances are obained from he mulivariae GARCH (1,1) using equaions (6a-c) for Model 1FI and (6a-d) for Model 2FI. The insrumen se ha we use in hese esimaions is our parsimonious se Z ha includes a consan, he lagged world marke reurn, and he lagged values of bond illiquidiy. Across all model specificaions, we observe a posiive and significan price of he world marke porfolio risk λ w. I economic erms, is magniude is beween 2.5 and 5.0, which is very consisen wih numerous sudies on he world marke inegraion (e.g., see De Sanis and Gerard, 1997; Bekaer, Harvey, and Lundblad, 2007). In conras, in Model 2FI he price of risk associaed wih changes in he currency baske, λ c, is insignifican for all counry samples. More imporanly, he parameer of our primary ineres, he fligh-o-liquidiy price of risk, λ LB negaive, as expeced, and significan a he sandard 5% level or less in all six esimaions across boh models. The poin esimaes of λ LB are around 0.25 for he enire sample of counries. Due o he absence of counry-specific parameers, all GMM sysems corresponding o he full, is 21

23 inegraion models are subsanially over-idenified. The J-saisics indicae ha we canno rejec he hypohesis ha he prices of world marke and bond illiquidiy risks are consan. While Table 7 shows ha he negaive significance of he bond illiquidiy price of risk is a very consisen oucome across differen esimaions, one canno exclude he possibiliy ha his resul is due o he omission of counry-specific risk facors. Therefore, in he GMM esimaions in Table 8 we consider wo parial inegraion (PI) models by accouning for local marke variance risk and local marke volailiy risk. The esimaion period is again for developed markes and for emerging markes. Model 1PI is based on equaion (4), and Model 2PI is based on equaion (5). The condiional esimaes of he variances and covariances are obained from he mulivariae GARCH (1,1) using equaions (6a-e). The insrumen se for Model 1PI includes a consan, he lagged world marke reurn, and he lagged values of bond illiquidiy. In Model 2PI, he insrumen se also includes he lagged values of he world dividend yield, he US erm spread, and he reurn on he currency baske deposi. Finally, o reduce he dimensionaliy of he sysem and faciliae he convergence of he GMM opimizaion algorihm, we omied he foreign exchange risk facor. This simplificaion o models (4) and (5) does no sacrifice any economic inuiion in esimaing our wo parial inegraion models, since he foreign exchange price of risk, λ c, urned ou o be unimporan in he full inegraion models 1FI and 2FI. As before, we again observe a posiive and significan risk premium coefficien λ w on he world sock marke porfolio across all esimaions. Noe ha in spie of he differences in model specificaions and he insrumens se (for Model 2PI), he slope coefficiens are sill consisenly wihin 2.5 and 5.0 range in he magniude. Also, similar o our earlier resuls in Table 7, we find once again ha he price of fligh-o-liquidiy risk, λ LB, is negaive and significan a he sandard 5% level in all esimaion and i is again larger for emerging markes. Is magniude is slighly larger a abou 0.60 across all counries. Based on he J-saisics, we again canno rejec he hypohesis ha he prices of world marke, bond illiquidiy, and local risks are consan. Thus, he fligh-o-liquidiy risk is consisenly priced under various models of full and parial inegraion. 22

24 This implies ha changes in he US Treasury bond illiquidiy have an imporan impac on global equiy reurns. In economic erms, he average annual premium aribued o he fligh-o-liquidiy risk, λ Cov 1 (, L ) LB r B, model specificaion., lies beween 0.35% and 0.75% across all counries depending on he 6. Conclusion In his paper, we offer a novel look a global equiy marke pricing. The exisence of large shifs in asse allocaion sraegies from less liquid asses around he world o more liquid and safe ones such as US Treasury bonds gives he rise o a significan price of he fligh-o-liquidiy/qualiy risk. We proxy he fligh-o-liquidiy by he percenage bid-ask spread of off-he-run US Treasuries wih mauriies of up o one year. Our resuls show ha he Treasury bond illiquidiy has srong predicive power for boh local sock marke reurns as well as sock marke illiquidiy. The fligh-o-liquidiy risk is priced in global equiy markes, and so i commands an economically and saisically significan premium across boh developed and emerging counries even afer conrolling for he world marke, exchange rae, and local risks, including sock marke illiquidiy. Our resuls indicae ha, ceeris paribus, he higher is he sensiiviy of an asse o he increase in he US Treasury bond illiquidiy he larger is is expeced reurn. Anoher, no leas imporan implicaion of our findings is ha in global markes i is much easier o accoun for he fligh-o-liquidiy/qualiy risk han he sock marke illiquidiy risk. Unlike sock marke illiquidiy ha has numerous alernaive measures (e.g., he proporion of zero reurns during a monh, he bid-ask spread, share urnover, ec.), all of which are difficul o measure boh a he local and global levels, he fligh-o-liquidiy/qualiy risk is measured by a variable which is easily observable and is very precise. 23

25 References Acharya, V.V., and L.H. Pedersen, 2005, Asse Pricing wih Liquidiy Risk, Journal of Financial Economics 77, Agnew J., and P. Balduzz 2007, Transfer Aciviy in 401(k) Plans, Working paper, Boson College. Amihud, Y., and H. Mendelson, 1986, Asse Pricing and he Bid-Ask Spread, Journal of Financial Economics 17, Amihud, Y., Illiquidiy and Sock Reurns: Cross-secion and Time-series Effecs, Journal of Financial Markes 5, Andersen, T.G., and B.E. Sørensen, 1996, GMM Esimaion of a Sochasic Volailiy Model: A Mone Carlo Sudy, Journal of Business and Economic Saisics 14, Baele, L. Bekaer, G., and K. Inghelbrech, 2007, The Deerminans of Sock and Bond Reurn Comovemens, Working paper, Columbia Universiy. Bekaer, G., E. Engsrom, and S. Grenadier, 2005, Sock and Bond Reurns wih Moody Invesors, Working paper, Columbia Universiy. Bekaer, G., C.R. Harvey, and C. Lundblad, 2007, Liquidiy and Expeced Reurns: Lessons form Emerging Markes, Review of Financial Sudies, forhcoming. Bekaer, G., and C.R. Harvey, 1995, Time-Varying World Marke Inegraion, Journal of Finance 50, Benson, G., and R. Hagerman, 1974, Deerminans of Bid-Ask Spreads in he Over-he-Couner Marke, Journal of Financial Economics 1, Bernarke, B.S. K.N. Kuner, 2005, Wha Explains he Sock Marke's Reacion o Federal Reserve Policy? Journal of Finance 60, Breen,W., L.R. Glosen, and R. Jagannahan, 1989, Economic Signifcance of Predicable Variaions in Sock Index Reurns, Journal of Finance 44, Brennan, M., and A. Subrahmanyam, 1996, Marke Microsrucure and Asse Pricing: On he Compensaion for Illiquidiy in Sock Reurns, Journal of Financial Economics 41, Campbell, J.Y, 1987, Sock Reurns and he Term Srucure, Journal of Financial Economics 18, Campbell, J.Y., and J. Ammer, 1993, Wha Moves he Sock and Bond Markes? A Variance Decomposiion for Long-Term Asse Reurns, Journal of Finance 48,

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