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Stock Market Declines and Liquidity

Authors

  • ALLAUDEEN HAMEED,

  • WENJIN KANG,

  • S. VISWANATHAN

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    • Allaudeen Hameed and Wenjin Kang are from the Department of Finance, NUS Business School, National University of Singapore. Lasse Pedersen is acting editor. S. Viswanathan is from the Fuqua School of Business, Duke University. We thank Viral Acharya; Yakov Amihud; Michael Brandt; Markus Brunnermeier; Andrew Ellul; Bob Engle; Doug Foster; Joel Hasbrouck; David Hsieh; Ravi Jagannathan; Frank de Jong; Pete Kyle; Christine Parlour; David Robinson; Ioanid Rosu; Avanidhar Subrahmanyam; Sheridan Titman; two anonymous referees; and participants at the NBER 2005 Microstructure Conference, 2007 American Finance Association Meeting, 2007 European Finance Association Meeting, 2008 First Erasmus Liquidity Conference, Australian National University, Case Western Reserve University, Erasmus University, Hong Kong University, Hong Kong University of Science and Technology, Nanyang Technological University, National University of Singapore, New York University, Peking University, University of Alberta, University of Evry (France), University of Melbourne, and University of Texas (Austin) for their comments. Hameed and Kang acknowledge financial support from the NUS Academic Research Grants and Viswanathan thanks IIMA Bangalore for their hospitality during year 2005 when this paper was started.


ABSTRACT

Consistent with recent theoretical models where binding capital constraints lead to sudden liquidity dry-ups, we find that negative market returns decrease stock liquidity, especially during times of tightness in the funding market. The asymmetric effect of changes in aggregate asset values on liquidity and commonality in liquidity cannot be fully explained by changes in demand for liquidity or volatility effects. We document interindustry spillover effects in liquidity, which are likely to arise from capital constraints in the market making sector. We also find economically significant returns to supplying liquidity following periods of large drops in market valuations.

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