Electronic copy available at: http://ssrn.com/abstract=1729408Electronic copy available at: http://ssrn.com/abstract=1729408

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Comatose Markets: What if liquidity is not the norm?

December 2010

Aswath Damodaran

Stern School of Business

adamodar@stern.nyu.edu

Electronic copy available at: http://ssrn.com/abstract=1729408Electronic copy available at: http://ssrn.com/abstract=1729408

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Comatose Markets: What if liquidity is not the norm? Much of financial theory and practice is built on the presumption that markets are

liquid. In a liquid market, you should be able to but or sell any asset, in any quantity, at

the prevailing market price and with no transactions costs. Using that definition, no asset

is completely liquid and there are wide variations in liquidity across asset classes, across

assets within each asset class, and across investors. After presenting evidence to back up

this proposition and recognizing that investors care about and price in illiquidity, we

evaluate how introducing illiquidity into the decision process not only alters portfolio

composition but has a divergent impact on investors with different time horizons and

investment strategies. The presence and pricing in of liquidity opens up profitable

opportunities for two classes of investors: long-term investors who care about less about

liquidity than the rest of the market (liquidity arbitrageurs) and investors who can time

shifts in market liquidity (liquidity timers). In illiquid markets, firms will also be more

sparing in their use of debt, will pay higher dividends, will buy back less stock and will

accumulate more cash.

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Much of financial theory and practice is built on the presumption that liquidity is

the norm and that illiquidity exists only in pockets, for a few stocks, in certain asset

classes (real estate, collectibles) and in small, emerging markets. Thus, investors are

advised to diversify across asset classes, largely ignoring differences in illiquidity across

them, and to buy under valued assets within each one, notwithstanding the fact that some

assets are much more illiquid than others. In corporate finance, almost of the discussion

of how firms should pick investments, whether they should fund these investments with

debt or equity, and how much they should pay in dividends largely ignores liquidity

concerns.

It is the during crises that we recognize the fragility of the liquidity assumption, as

order imbalances bring trading to a halt on even the most widely traded securities and

transactions costs mount for both investors and firms. Rather than view these bouts of

illiquidity as aberrations, it is more prudent to accept them as a given and consider how

best to incorporate the potential for illiquidity into both investment policy and corporate

financial decisions.

Defining and Measuring Liquidity In a world with perfect liquidity, you should be able to buy or sell an asset

instantaneously at the prevailing market price and bear no transactions costs. Using that

definition, no asset market is completely liquid and the degree of illiquidity can be

measured in one of two ways. The first is in terms of transactions cost: the greater the

costs associated with trading an asset, the less liquid that asset. The other is in terms of

“waiting to trade” time: when an asset is illiquid, you have to wait longer to sell that asset

and the wait time becomes a measure of illiquidity.

The Transactions Cost Measure

When trading most assets, the transactions cost that is most visible is the up front

brokerage or trading cost. While this might be the only explicit cost that you pay for

trading some assets, there are two other costs that you will incur in the course of trading

other assets that can dwarf the commission cost. The first is the spread between the price

at which you can buy an asset (the dealer’s ask price) and the price at which you can sell

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the same asset at the same point in time (the dealer’s bid price). The second is the price

impact you can create by trading on an asset, pushing the price up when buying the asset

and pushing it down while selling.

Brokerage Costs

In most asset markets, the transactions cost takes the form of a brokerage cost at

the time of the transaction. Since the function of the broker is to bring together a willing

buyer and seller in a transaction, the cost of that intermediation will vary across assets

and markets. In particular, it should be a function of the following:

a. Standardization of product: A broker’s job is made much easier by standardization.

One share of IBM is exactly identical to any other share, thus eliminating the need for

the broker to characterize or vouch for the product to potential buyers. In contrast,

one real estate property is seldom identical to another property and brokers have to

play the role of information providers.

b. Depth and breadth of the market: The greater the number of investors trading in a

product, the easier it will be for the broker to arrange a transaction. Therefore, you

would expect brokerage costs to be smaller for treasury bonds than for collectibles or

fine art. After all, there are few potential buyers for a painting by Picasso and the fees

charged by auctioneers will reflect the cost associated with finding a buyer.

c. Competition among brokers: As competition increases across brokers, the brokerage

costs should decrease. The ending of fixed commissions for stock trading on Wall

Street in 1975 opened up the market to discount brokerage houses and a dramatic

drop in brokerage costs.

As a consequence of differences on these dimensions, the brokerage cost will be much

higher in some markets than others and include compensation for services beyond just

intermediation, and even across assets within each market.

The Bid-Ask Spread

With traded securities, there is a difference between what a buyer will pay and the

seller will receive, at the same point in time for the same asset. The bid-ask spread refers

to the difference between the price at which you can buy and the one at which you can

sell, and the spread is set by a dealer or market maker. There are three types of costs that

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the dealer faces that this spread is designed to cover. The first is the cost of holding

inventory, the second is the cost of processing orders and the final cost is the cost of

trading with more informed investors. The spread has to be large enough to cover these

costs and yield a reasonable profit to the market maker on his or her investment in the

profession.

1. The Inventory Rationale

Consider a market maker or a specialist on the floor of the exchange who has to

quote bid prices and ask prices, at which she is obligated to execute buy and sell orders

from investors. These investors, themselves, could be trading because of information they

have received (informed traders), for liquidity (liquidity traders) or based upon their

belief that an asset is under or over valued (value traders). In such a market, if the market

makers set the bid price too high, they will accumulate an inventory of the stock. If

market makers set the ask price too low, they will find themselves with a large short

position in the stock. In either case, there is a cost to the market makers that they will

attempt to recover by increasing the spread between the bid and ask prices.

Market makers also operate with inventory constraints, some of which are

externally imposed (by the exchanges or regulatory agencies) and some of which are

internally imposed (due to limited capital and risk). As the market makers’ inventory

positions deviates from their optimal positions, they bear a cost and will try to adjust the

bid and ask prices to get back to their desired position. If the inventory is too high, the

bid price is too high; if the inventory is too low or negative, the ask price is too low.

2. The Processing Cost Argument

Since market makers incur a processing cost with the paperwork and fees

associated with orders, the bid-ask spread has to cover, at the minimum, these costs.

While these costs are likely to be very small for large orders of stocks traded on the

exchanges, they become larger for small orders of stocks that might be traded only

through a dealership market. Furthermore, since a large proportion of this cost is fixed,

these costs as a percentage of the price will generally be higher for low-priced stocks than

for high-priced stocks. Technology clearly has reduced the processing cost associated

with trading securities as computerized systems take over from traditional record keepers.

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These cost reductions should be greatest for stocks where the bulk of the trades are small

trades - small stocks held by individual rather than institutional investors.

3. The Adverse Selection Problem

The adverse selection problem arises from the different motives investors have for

trading on an asset - liquidity, information and views on valuation. Since investors do not

announce their reasons for trading at the time of the trades, the market maker always runs

the risk of trading against more informed investors. Since the expected profits from such

trading are negative, the market maker has to charge an average spread that is large

enough to compensate for such losses. This theory would suggest that spreads will

increase with the proportion of informed traders in an asset market, the “differential”

information possessed, on average, by these traders and uncertainty about future

information on the asset.

The Price Impact

Most investors assume that trading costs are less for large, institutional investors

than for smaller, individual investors. While this is true for brokerage commissions and

perhaps even for the bid-ask spread, it is not the case for the third component: larger

investors bear more substantial costs than do smaller investors and that is in the impact

that trading has on prices. Investors with large portfolios make larger buy and sell trades

and have a much larger effect on stock prices as they trade, pushing up prices as they buy

and down as they sell, reducing investment profits.

There are two reasons for the price impact. The first is that markets are not

completely liquid. A large trade can create an imbalance between buy and sell orders, and

the only way in which this imbalance can be resolved is with a price change. This price

change that arises from lack of liquidity, will generally be temporary and will be reversed

as liquidity returns to the market. The second reason for the price impact is informational.

A large trade attracts the attention of other investors in that asset market because if might

be motivated by new information that the trader possesses. Notwithstanding claims to the

contrary, investors usually assume, with good reason, that an investor buying a large

block is buying in advance of good news and that an investor selling a large block has

come into possession of some negative news about the company. Unlike the trading

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imbalance effect, this price effect will not dissipate quickly, since investors will wait for

confirmation.

Waiting time as a measure of liquidity

A seller, facing an illiquid market, has two choices. He can the cut the asking

price and still try to sell the asset, thus increasing transactions costs, or he can wait for the

market to become more liquid. This waiting time creates two costs for the seller. The first

is time value, where the investor has to delay receiving the sales proceeds for weeks or

even months. The second is that the keeping the asset and maintaining it in selling

condition may create additional costs. There are two other risks to waiting to sell. First,

the price of an asset that an investor wants to sell may fall further while the investor waits

to trade, and this, in turn, can lead to one of two consequences. One is that the investor

does eventually sell, but at a much lower price, reducing expected profits from the

investment. The other is that the price falls so much that the asset that the investor does

not trade at all. A similar calculus applies when an investor wants to buy an asset that he

or she thinks is undervalued.

In many real asset markets, illiquidity is more likely to manifest itself in extended

waiting times than in higher transactions costs, for a variety of reasons. First, sellers may

be psychologically more willing to bear waiting costs than take a price cut; thus, a person

trying to sell his residence may feel less pain waiting two years to sell the property than

taking a price cut of 15%, even though the financial impact may be the same. Second, the

financing structure of some real assets may push sellers to wait rather than sell. Again,

using real estate as the example, mortgages are tied to individual properties; if a property

is sold at a price well below the mortgage due, the borrower will have to come up with

the cash to cover the difference. In real estate, a statistic that is tracked and reported is

“days on market (DOM)”, measuring the number of days a typical listed property has

been on the market. This statistic can be used to measure not only variations in liquidity

across geographical areas but also across time.

Why does liquidity matter? Before discussing how to measure liquidity and the evidence on illiquidity in

markets, it is important that we establish why we care. As we will see in this section,

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much of financial theory is predicated on the assumption that assets are liquid or that the

costs of illiquidity are small.

Asset Pricing & Valuation

There are three approaches that can be used to value an asset and we make

implicit assumptions about liquidity in all three.

a. In intrinsic valuation, we value an asset by discounting expected cash flows back at a

risk adjusted discounted rate. In computing expected cash flows, we implicitly

consider probability-weighted averages of cash flows under different scenarios, but

we don’t consider the fact that there may be more liquidity under some scenarios than

in others. Thus, cash flows in good economic times, when funds are easy to access, is

treated the same as a cash flow of $ 100 million in bad times, when funds are more

likely to be constrained. When computing risk adjusted discount rates, if we follow

conventional financial theory, we estimate the riskiness of an asset by looking at the

market risk in that asset (captured by a beta or betas) and a market wide risk premium

for that risk (equity risk premium). Nowhere in the computation is a consideration of

the fact that some investments may be more liquid than others and that the illiquidity

can generate a cost for investors in the future.

b. In relative valuation, we value an asset by looking at how similar assets are priced by

the market. Here again, there is little consideration given to liquidity. Holding all else

constant, a stock that trades at a price earnings ratio of 12 is viewed as cheap if other

equities that share its characteristics (same sector, growth rate) trade at higher price

earnings ratio. The fact that the “cheap” stock is lightly traded is at best treated as an

after thought and at worst, completely ignored.

c. In contingent claim valuation, we draw on established option pricing models, such as

the Black-Scholes and the binomial. Though these models are elegant, they are based

upon the implicit assumption that assets are liquid and that transactions costs are

negligible. The problem is magnified when we treat undeveloped natural resource

reserves, pharmaceutical or technological patents and opportunities to expand into

large markets as real options, where the underlying assets are not traded and liquidity

is a mirage.

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If we accept the premise that liquidity varies both across assets, and illiquidity creates

costs for investors, it stands to reason that using conventional valuation models will

attach too high a value for illiquid assets. If overall market liquidity can change over

time, not adjusting for those changes will lead us to find entire markets to be under

valued during crisis periods. Finally, if some investors care more about illiquidity than

others, failing to incorporate the illiquidity cost into value will lead us to ignore the

reality that the same asset can be valued differently by different investors, especially

during periods of market illiquidity.

Practitioners have developed tweaks within each of these approaches to allow for

illiquidity. Appraisers who use discounted cash flow models to value private businesses

generally apply a significant illiquidity discount to their estimated values, to allow for the

fact that private businesses are not traded. Equity research analysts will sometimes factor

in the trading volume and bid-ask spreads when comparing the pricing of companies

within their peer groups and there are variants on conventional option pricing models that

bring in illiquidity costs into the estimate. The adjustments to conventional models,

though, have tended to be ad hoc and often arbitrary, with wide divergences in practice.

Portfolio Management Since Harry Markowitz laid out the rationale for diversification and presented his

argument that a diversified portfolio will generate a much better risk/return trade off than

an undiversified one, financial theorist have preached the mantra of diversification to

investors and argued that diversified portfolios offer the best risk/return tradeoff.

However, following Markowitz, we have also defined risk as the standard deviation or

volatility in stock prices and paid no explicit attention to liquidity risk and its

consequences for investing.

Asset Allocation

In conventional portfolio theory, asset allocation is a function of an investor’s risk

aversion and the market timing abilities. If investors are not good at timing markets, and

the preponderance of the evidence suggests that they not, they should diversify across

asset classes, based upon the expected return and the standard deviation of each asset

class as well as the covariances across them, to find the mix that delivers the highest

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expected return for any desired level of risk. If investors have the capacity to time

markets, they can alter this mix to reflect their views on which markets are cheap (and

will out perform) and which ones are expensive.

In this algorithm for maximizing returns, though, our measures of standard

deviation and covariance are derived from past data and there is the implicit assumption

that all asset classes are equally liquid. This assumption is what allows up to use expected

returns, standard deviations and covariances from past data and use these numbers as

inputs into the asset allocation decision. If there are differences in liquidity across asset

classes, there is little in the optimization process that incorporates these differences;

lower liquidity does not always manifest itself in higher standard deviations. In fact, as

trading volume and liquidity in an asset market decreases, the standard deviation usually

drops, making illiquid assets look less risky. Depending on these variances to make asset

allocation judgments will lead investors to over invest in illiquid asset classes, as did

many pension funds and portfolio managers who invested in private equity and real estate

in 2007 and 2008.

Security Selection

The optimization process used to allocate a portfolio across asset classes, based

upon maximizing expected returns for any given level of risk is extended when we select

assets within each asset classes. With stocks, for instance, the expected returns on

individual stocks, in conjunction with the variance-covariance matrix across these stocks,

is used to determine which stocks to hold and in what proportions. Here again, though,

the failure to explicitly control for liquidity differences across assets can lead investors to

invest too much in less liquid stocks.

Even portfolio managers who don’t use optimization techniques make their

investment choices without explicitly considering illiquidity. Consider, for instance, a

strategy of investing in small market cap companies with low price earnings. While

studies back up the notion that this is a winning strategy in the long term, what these

studies fail to consider is the additional transaction cost burden faced by investors in

these companies; small companies tend be less liquid and create more transactions costs

for their owners in the form of higher bid-ask spreads and larger price impact.

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Finally, the argument that investors in most publicly traded firms should hold

dispersed portfolios is conditioned on the assumption that the transactions costs of

diversifying are low. If investments are illiquid, and diversification is therefore

expensive, it is entirely possible that the advice has to be modified to allow for the trade

off between diversification and transactions costs.

Market Efficiency

Since financial market theorists posited the notion of an efficient market, there

has been tension in portfolio management between those who believe that markets are

efficient and that active portfolio management is pointless, and those who argue that

active portfolio management can deliver results because markets are inefficient. The

question of whether markets are efficient is an empirical one and there are literally

hundreds of studies that try to answer this question by testing out the viability of

investment strategies that claim to “beat the market”.

In fact, it is the results from these studies that have provided ammunition to those

who argue that markets are not efficient. If these studies are to believed, the list of

characteristics that can be mined to generate profits seems endless: small market cap

companies, low priced stocks, companies with high dividend yields and low price to book

ratios and companies with earnings/price momentum all seem to deliver higher returns

than they should. However, most of these studies also pay only lip service to transactions

costs and provide little more than the platitude that the excess returns look too large to be

explained by transactions costs or lack of liquidity. However, the congruence between

stocks that look cheap in these studies and illiquidity is too high to be a coincidence. It is

also a testimonial to the presence of transactions costs (and illiquidity) that so few

portfolio managers who adopt these “beat-the-market” schemes actually end up beating

the market.

Believers in efficient markets face a friction of their own, when it comes to

liquidity. If markets are truly efficient and investors came to that acceptance, they would

invest in passive portfolios or index funds.1 If they did so, there would be little or no

1 Grossman, S. J. and J.E. Stiglitz, 1980, On the Impossibility of Efficient Markets, American Economic Review, v70, 393-408.

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trading, markets would become illiquid, and market inefficiencies would become

commonplace.

Leverage in Investment Strategies

Investors can augment the returns that they make on investments by using

borrowed money to fund them. Conventional financial theory bases how much you

should borrow to the riskiness of the investments that you are funding. At one extreme,

you can borrow 100% of your investment, if you are investing in a riskless asset. That is,

in fact, the basis for arbitrage, where you invest none of your money (since all of it is

borrowed), take no risk (since the returns are guaranteed) and make more than the risk

free rate (the arbitrage). Option pricing and futures pricing models are built on this

strategy. As the riskiness of the assets increases, the amount you can borrow to fund

those assets should decrease.

Nowhere in this process is liquidity explicitly considered. To the extent that even

a riskless investment may be illiquid during the investment period, borrowing 100% to

fund that investment can be catastrophic for an investor who is forced to exit the strategy

early. Common sense suggests that liquidity has to be explicitly considered when

deciding on the right amount of financial leverage to fund that strategy, with leverage

decreasing as illiquidity increases.

Types of investment strategies

Investment strategies can be short term or long term, be based upon information

or value judgments, or can be momentum or contrarian in nature, and the dependence on

liquidity varies widely across strategies:

1. Is the valuation assessment based upon private information or is based upon public

information? Private information tends to have a short shelf life in financial markets,

and the risks of sitting on private information are much greater than the risks of

waiting when the valuation assessment is based upon information that is already

public. Thus, the capacity to trade quickly and with minimal price impact looms

much larger when the strategy is to buy on the rumors (or information) of a possible

takeover than it would be in a strategy of buying low PE ratio stocks.

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2. How active is the market for information? Building on the first point, the effect of

illiquidity, when one has valuable information, is much greater in markets where

there are other investors actively searching for the same information. Again, in

practical terms, the importance of liquidity is greater when there are dozens of

analysts following the targeted stock or investment than when there are few other

investors paying attention to the stock.

3. How long term or short term is the strategy? While this generalization does not

always hold, short-term strategies are much likely to be affected by illiquidity than

longer term strategies. Part of the reason is that short term strategies, by definition,

will lead to more trading, and thus a greater exposure to transactions costs (and

illiquidity). It is also likely that short term strategies are more likely to be motivated

by private information, whereas long term strategies are more likely to be motivated

by views on value.

4. Is the investment strategy a “contrarian” or “momentum” strategy? In a contrarian

strategy, where investors are investing against the prevailing tide (buying when others

are selling or selling when others are buying), the importance of liquidity is likely to

be smaller precisely because of this behavior. In contrast, the effects of illiquidity in a

“momentum” strategy are likely to be higher since the investor is buying when other

investors are buying and selling when others are selling.

In summary, the costs of illiquidity are likely to be greatest for short-term investment

strategies, based upon private information or momentum, and in markets with active

information gathering. It will be less of an issue for long-term investment strategies based

upon public information and for contrarian strategies.

Corporate Finance

The belief that markets are liquid also underlies corporate financial theory. In

capital budgeting, capital structure and dividend policy, much of what we propound as

good corporate finance practice is built on the presumption of liquid markets for both

financial and real assets.

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Investment Policy

Every firm has to make resource allocation decisions; determining which

investments to take and which ones to reject is a key component of running any business.

If the objective in decision-making is to maximize the value of the firm, the way we

assess projects has to be consistent with that objective. In this section, we will argue that

every component of investment/project analysis makes implicit or explicit assumptions

about liquidity.

Investment Decision Rules

In the last four decades, we have seen a shift away from accounting profitability

measures to cash flow based decision rules. Thus, rather than assess projects on the basis

of return on investment or return on equity, corporate financial theorists have argued that

we make better decisions by considering cash flows (rather than earnings) and

discounting these cash flows back to the present, using a risk-adjusted discount rate (a

cost of equity or capital).

While the shift from accounting earnings to cash flows is a good one, consider the

two basic discounted cash flow rules that are generally used in capital budgeting. The

first is the net present value, computed as the sum of the present values of expected cash

flows on an investment over its life. The other is the internal rate of returns, the discount

rate that results in a zero net present value. Most corporate finance textbooks go on to

conclude that the net present value rule is superior to the internal rate of return rule

because it is more consistent with value maximization.2 In fact, a business should take

every positive net present value investment it is faced with, if it wants to maximize its

value. This conclusion, though, is true only if firms have unlimited access to fairly priced

capital. Put differently, the transactions costs (including price impact) of raising new debt

and equity capital have to be zero or close to zero. In fact, it is easy to show that as the

cost of accessing capital increases, it is no longer be sensible or rational for a firm to

invest in every positive net present value investment.

2 There are two other side benefits that are offered for the net present value rule over the internal rate of return rule. The first is that there can be only one net present value for an investment, whereas there can be multiple internal rates of return. The other is that the internal rate of return is based on the assumption that cash flows can be reinvested at the internal rate of return, whereas the net present value is based on the more sustainable assumption that cash flows get reinvested at the cost of capital.

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Cash flows (on liquid versus illiquid assets)

In most conventional cash flow computations, we start with earnings and net out

reinvestment needs to get to cash flows. Thus, we assume that the firm will be able to

use these cash flows as it sees fit; it can invest the cash flow in other projects, hold it as a

cash balance or draw on it to pay dividends and service debt. While this may be a

reasonable assumption in some cases, it may not in the following circumstances:

a. Regulatory Restrictions: In some regulated businesses, cash flows that are

generated may need to be held in the business to meet regulatory constraints.

Thus, a bank that has excess cash flows may be unable to pay that cash out, if the

payout will reduce its equity capital below a regulatory requirement.

b. Dividend/Book Value Restrictions: Some countries have restrictions not only on

how much can be paid in dividends but also on book value. In many European

markets, companies are required to maintain a positive book value for equity and

dividends or buybacks that cause book value of equity to drop below zero are not

allowed.

c. Debt covenants: When firms borrow money, lenders often attach covenants to the

loans that can restrict how the firm uses its cash flows. For instance, a firm may

be required to hold a minimum cash balance (rather than pay it out) or use the

cash to bring working capital up to a specified level.

d. Sovereign remittance restrictions: As companies expand into emerging markets,

looking for growth, they are also increasingly exposed to restrictions that some

countries impose on repatriating the cash flows back to the parent entity. In some

cases, companies are required to reinvest the cash back into those countries and in

other cases, there are restrictions on how much cash can be repatriated in any

period.

e. Exchange rate effects: When cash flows in a foreign currency have to be

converted into domestic currency cash flows, we have to make assumptions about

exchange rates in the future. With liquid currencies, we can obtain these expected

rates by looking at forward or futures markets but with illiquid currencies where

forward/futures rates are unavailable, we not only have to estimate expected

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future rates but also assume that the markets will be liquid enough for this

conversion to occur in the future.

The net effect of these restrictions is that what we compute as cash flow may not match

up to a “liquid” cash flow. When we treat all cash flows equivalently, we are also

assuming that none of these restrictions are binding.

Cost of equity and capital

Reviewing first principles in investment analysis, the discount rate for the cash

flows can be a cost of equity (if the cash flows are post-debt cash flows) or a cost of

capital. In making these estimates, though we generally consider do not consider the

liquidity risk in raising either equity or debt. We compute the cost of equity by looking at

the market risk in the equity investment and the cost of debt based upon default risk, and

ignore the costs that can be created by illiquidity in either market. How would illiquidity

manifest itself in these costs? If a market is illiquid, there will be flotation or issuance

cost that will be substantial and incorporating this cost will raise the cost of all financing.

Thus, if the issuance cost for new equity is 10% of the proceeds, the cost of equity will

have to be higher to cover this issuance cost.

By ignoring illiquidity, we are understating the costs of equity and capital for all

firms but more so for smaller firms that face more costs in raising capital and emerging

market firms that operate in illiquid markets. Across time, we are understating costs of

equity and debt during times of crisis, when illiquidity increases across the board for all

firms, and again more so for some firms than others.

Capital Structure

Every firm faces a trade off between using owners’ funds (equity) or borrowed

money (debt), when funding investments. Debt provides significant tax advantages, since

interest expenses are fully tax deductible whereas cash flows to equity (dividends,

buybacks) have to come out of after-tax cash flows. However, debt also increases the

likelihood of default and bankruptcy, while also exacerbating agency problems: what is

good for equity investors may not be good for lenders who respond by restricting the firm

through covenants. While this trade off, by itself, is unaffected by illiquidity, the tools we

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use to arrive at the optimal mix of debt and equity are affected by our assumptions on

liquidity.

How much debt to use…

One technique that is used to assess the optimal mix of debt and equity for a

company is to find the mix of debt and equity that minimizes the cost of capital. In the

last section, we noted how ignoring liquidity can result in the costs of equity, debt and

capital being understated for all firms, and more so for firms that face difficulty accessing

capital markets and during periods of market illiquidity. To the extent that illiquidity

affects both debt and equity markets equally, the approach will still work, even if we do

not incorporate the effects of illiquidity into the cost of capital. However, if illiquidity is

more of problem in one market than the other, using the cost of capital to arrive at an

optimal debt mix will yield a misleading result. Thus, if equity markets are illiquid but

bank lending is easier to access, the cost of capital approach will generate an optimal debt

ratio that is too low, relative to the true optimal. If the reverse applies, i.e., equity markets

are liquid but debt markets are costly to access, the cost of capital approach will yield too

high an optimal debt ratio.

The other approach uses to come up with the optimal financing mix is the

adjusted present value approach, where the value of debt is assessed by adding the tax

benefits of debt to the value of the firm with no debt and then subtracting out the

expected bankruptcy costs. The expected bankruptcy costs can be affected by illiquidity

on two dimensions:

• The probability of bankruptcy reflects the likelihood that the firm will be unable to

meet an obligated debt payment. Holding all else constant, the more illiquid a market

is, the greater is the likelihood that bad times will lead to default. In a liquid market,

even troubled firms may be able to raise fresh capital to ward off default, whereas this

option is less accessible in an illiquid market.

• The cost of bankruptcy measures how much the firm will lose as a consequence of

default. Assuming that the assets of the firm will be sold to cover its unpaid

obligations, the cost of distress will be lower, if asset markets are liquid. If asset

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markets are not liquid, a distressed firm will have to sell its assets at a much bigger

discount.

If we ignore illiquidity in making capital structure choices, as we often do, it is entirely

possible that the optimal debt ratios that we estimate will be incorrect, and more so for

small market cap and private firms that are more exposed to illiquidity.

Type of Debt

Assuming that you have arrived at the right mix of debt and equity for your firm,

you have to decide on the type of debt to take – short term or long term, dollar or euro,

fixed or floating and straight or convertible. The conventional corporate finance principle

on this choice is simple: match the debt you take to the assets you fund with the debt.

Thus, long-term dollar debt should be used to fund a long-term project that generates

cash flows in dollars. The rationale for this approach is reduced default risk: you are less

likely to default if the cash flows on your debt match up to the cash flows on your assets.

How does liquidity play into this decision? The matching principle will fail if

there are significant differences in liquidity across different types of debt and variations

in liquidity over time. Thus, a firm with a project in Indonesia may choose to use dollar

debt to fund the rupiah cash flow project because rupiah bonds are significantly less

liquid than dollar denominated bonds. In a market where liquidity varies over time, firms

may decide to borrow long term during periods of high liquidity, even if their projects are

short term, so that they are not exposed to the risk of having to access markets during

periods of low liquidity. In effect, the choice of debt becomes a trade off between the

costs of illiquidity and the costs of mismatching debt to assets.

Dividend Policy

The final piece of the corporate finance analysis confronts two questions: How

much cash should a firm return to its stockholders each period? What form of cash return,

dividends or stock buybacks, is the right one to use? In answering these questions, we do

make implicit assumptions about liquidity.

19

How much to return to stockholders?

The basic principle that underlies dividend policy in conventional corporate

finance is that if a firm cannot find investments that generate a return that exceeds its cost

of capital, it should return that cash to its stockholders. Extending that principle, there is

also little need for a cash balance, beyond what the firm needs to meet its operating

requirements. This conclusion, of course, though is built on the presumption that capital

markets are liquid and accessible and that this firm will be able to go out and raise capital

in future periods to cover any good investments that it may encounter.

To the extent that equity markets or debt markets are illiquid, the

recommendations to return whatever excess cash you have to stockholders and maintain a

minimal cash balance have to be modified. In general, as the cost of accessing capital

markets increases, the need to maintain a cash balance to meet future investment needs

will also increase and the capacity to return cash to stockholders will decrease.

Dividends versus Stock buybacks

The question of whether to pay dividends or buy back stock has generally been

framed around the tax issue. If investors are taxed more heavily on dividends than capital

gains, it has been argued that stock buybacks will generate more value for investors.

Since the tax rate on dividends has historically increased with wealth level, this would

suggest that companies with wealthy investors should pay less in dividends and buy back

more stock.3

There is, however, also a liquidity difference. Dividends represent cash in the

hand for investors who get them. Stock buybacks, however, require that you be able to

either tender your shares in the buy back or sell your shares in the after market to collect

your capital gains. To the extent that markets are illiquid, stock buybacks can be viewed

as less liquid cash flows than dividends. Thus, if markets become more illiquid, a

company that has planned to return cash to its stockholders may be more inclined to

return them as dividends rather than buy back shares.

3 In 2003, the tax law was changed to set taxes on dividends equal to the tax on capital gains. Prior to that, investors paid their marginal ordinary tax rate on dividends, whereas the capital gains tax rate was fixed. Wealthier investors paid 40%, 50% or more on dividends while paying 20% or so on capital gains.

20

Evidence on Liquidity As we noted in the introductory section, illiquidity can be measured in one of two

ways, transactions costs from trading or the waiting time to trade. In this section, we will

examine the empirical evidence on the differences in liquidity across markets but also

within markets, both across individual assets and across time. We also look at the cost of

illiquidity by looking at what investors demand as compensation for buying illiquid

assets.

The extent of illiquidity Most of the empirical evidence accumulated over time looks at the transactions

costs of trading. Not surprisingly, researchers find big difference in liquidity across asset

classes, with financial asset markets generally being more liquid that real asset markets.

With each market, liquidity varies widely across individual assets and over time.

Across Asset Classes and Markets

As we noted earlier, in the last two decades, investors have been advised to add real

estate, emerging market stocks, commodities and other real assets to their portfolios, and

to invest in hedge funds and private equity portfolios, many of which hold non-traded

companies and assets. While the risk/return trade off can look alluring, there are also

significant liquidity differences across asset classes and markets.

Generally speaking, financial assets are the most liquid asset class, partly because

they are sold in standardized, small units and partly because there are more traders in the

markets. Even within financial assets, though, there are differences, with the most liquid

market being the one for US treasuries, where the depth and width of the market

generates miniscule bid-ask spreads and instantaneous execution. For instance, the typical

bid-ask spread on a Treasury bill is less than 0.1% of the price. The spreads on corporate

bonds tend to be larger than the spreads on government bonds, with safer (higher rated)

and more liquid corporate bonds having lower spreads than riskier (lower rated) and less

liquid corporate bonds. Stocks in developed markets are, for the most part, liquid, but the

degree of liquidity varies across stocks and across time. The spreads in emerging equity

markets are higher than the spreads on U.S. markets, reflecting the lower liquidity in

those markets and the smaller market capitalization of the traded firms.

21

If the cost of trading securities can be substantial, it is even more significant for assets

that are not traded regularly such as real assets or equity positions in privately owned

businesses. Real assets can range from commodities to real estate to fine art and the

transactions costs associated with trading these assets can also vary substantially. The

smallest transactions costs are associated with precious commodities – gold, silver or

diamonds – since they tend to come in standardized units and are traded on commodity

exchanges. In real estate, transactions cost can be a significant proportion of the real

estate property value, with the brokers on the seller and buyer side splitting the

difference. In residential real estate, the costs tend to be at the higher end of the scale,

ranging from 4-6% of housing value for just the brokerage fees, with legal and other

transactions costs adding to that number. In commercial real estate, where property

values tend to be higher, the brokerage costs tend to be a lower proportion of property

value, with other transactions costs again adding to the mix. With real estate, in

particular, the stated commission costs understate the true costs because they ignore two

other costs; the price impact from having to sell a property quickly or the cost of waiting

to sell a property, in a down market.

The trading costs associated with buying and selling a private business can range

from substantial to prohibitive, depending upon the size of the business, the composition

of its assets and its profitability. There are relatively few potential buyers and the search

costs associated with finding these buyers will be high. Later in this paper, we will look

at the conventional practice of applying 20-30% illiquidity discounts to the values of

private businesses under the microscope. The difficulties associated with selling private

businesses can spill over into smaller equity stakes in these businesses. Thus, private

equity investors and venture capitalists are exposed to the potential illiquidity of their

private company investments. Investors in private equity funds were made painfully

aware of illiquidity costs, when some of them tried to liquidate their positions in the

aftermath of the market crisis in 2008.4 In summary, liquidity can and will vary widely

4 College endowments, in particular, took a hit, when they tried to liquidate private equity investments in 2009. Harvard and Dartmouth University, which had moved a significant part of their overall endowment into private equity funds and real estate in the 2005-2007 time period lost significant portions of their funds, as they tried to liquidate their holdings after the market crisis in 2008.

22

across asset classes and markets and the resulting costs have to be considered while

investing in them.

Within asset classes

Within each asset class, there can be wide variations in liquidity and transactions

costs across individual assets. Thus, while equities and corporate bonds in the United

States are collectively liquid, there are individual stocks and classes of bonds that are

illiquid. Even within other asset classes, such as real estate and private equity, some

properties and private equity funds are more liquid than others. In this section, we will

focus on differences in liquidity across stocks within the US equity market to illustrate

this phenomenon.

US Equities

As we noted in the first section, there are three components to transactions costs:

brokerage costs, bid-ask spreads and price impact. The differences across stocks are

smallest on the first component, but are much larger on the latter two components.

Interestingly, while small investors bear a bigger burden than larger investors on

brokerage costs and arguably on bid-ask spreads, they operate at an advantage to larger

investors on the price impact; a large institutional investor will create more of a price

impact when trading than a small individual investor.

a. Brokerage costs

The differences across stocks are smallest on the first component – brokerage

costs – at least in absolute terms. Thus, the $8.95 you pay as a brokerage commission for

trading shares on a discount brokerage service will be a smaller percent of your overall

investment, if you buy 1000 shares instead of 100, or buy shares at $100/share rather than

at $ 10/share.

That being said, there are three dimensions, where your costs can vary across

trades. The first is that the brokerage cost will be higher as a percent of your investment

for lower-priced stocks than for higher priced one. The second is that odd lots will create

larger transactions costs than even lots (of 100, 1000 etc). The third is that the brokerage

costs will be higher for buying stocks listed and traded on foreign markets than on

domestic ones.

23

b. Bid-ask spreads

The medina bid-ask spread was $0.03 of the price for stocks listed on the New

York Stock Exchange, which worked out to 0.113% of the stock price in 2005. On the

NASDAQ, the median spread was a little higher at $0.046, estimated to be 0.22% of the

stock price, in 2005. This average, however, obscures the large differences in the cost as

a percentage of the price across stocks, based upon capitalization, stock price level and

trading volume. A study5 by Thomas Loeb in 1983, for instance, reported the spread for

small orders as a percentage of the stock price for companies as a function of their marker

capitalization. These results are summarized in Figure 1:

While the dollar spread is not that different across market capitalization classes, the

smallest companies also tend to have lower priced stocks. Consequently, the spread is as

high as 6.55% of the price, for small capitalization stocks and as low as 0.52% of the

price for large capitalization companies. Another study by Huang and Stoll found that the

stocks in the top 20% in terms of trading volume had an average spread of only 0.62% as

a percent of the market price while the stocks in the bottom 20% had a spread of 2.06%. 5 See “Trading Costs: The Critical Link Between Investment Information and Results” in the Financial Analysts Journal, May/June 1983.

Figure 1: Prices and Spreads by Market Cap

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

Market Capitalization Class

Pri

ce &

Sp

read

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

Sp

read

as

% o

f P

rice

Average Price Average Spread Spread/Price

Average Price $4.58 $10.30 $15.16 $18.27 $21.85 $28.31 $35.43 $44.34 $52.40

Average Spread $0.30 $0.42 $0.46 $0.34 $0.32 $0.32 $0.27 $0.29 $0.27

Spread/Price 6.55% 4.07% 3.03% 1.86% 1.46% 1.13% 0.76% 0.65% 0.52%

Smallest 2 3 4 5 6 7 8 Largest

24

6There are also large differences in bid-ask spreads across different exchanges in the

United States. Looking at only NASDAQ stocks, Kothare and Laux (1995) found7 that

the average was almost 6% of the price in 1992, and much higher for low-price stocks on

the exchange. Some of the difference can be attributed to the fact that NASDAQ stocks

are generally much smaller (in terms of market capitalization) and riskier than stocks

listed on the NYSE or AMEX. You could argue that these studies are dated and that

there have been significant changes in both the way markets are structured and spreads

are set in financial markets. In particular, after studies found that spreads on the

NASDAQ might have been manipulated by specialists, there was significant legal

pressure brought on the exchange to alter the way in which spreads were set. This was

followed by the New York Stock Exchange shifting from a long tradition of quoting

spreads in 1/16 and 1/8 to decimals. Have these changes made a dramatic difference? On

average, spreads have declined but the drop has been much greater for smaller, less liquid

stocks.

A number of studies have looked at the variables that determine (or, at the very

least, correlate with) the bid-ask spread. Studies find that the spread as a percentage of

the price is correlated negatively with the price level, volume and the number of market

makers, and positively with volatility.8 Each of these findings is consistent with the

theory on the bid-ask spread. The negative correlation with price level can be explained

by the higher processing cost as a percentage of the price. Higher volume reduces the

need for market makers to maintain inventory and also allows them to turn over their

inventory rapidly, resulting in lower inventory costs. The higher volatility leads to higher

bid-ask spreads partly because the adverse selection problem is greater for more volatile

stocks; there will generally be more informed traders, a greater “information differential”

and greater uncertainty about future information on these stocks. It is also worth noting

6 Huang, R. and H.R. Stoll. 1987. The Components of the Bid-Ask Spread: A General Approach, Review of Financial Studies, v10, 995-1034. 7 See “Trading Costs and the Trading Systems for NASDAQ stocks” by M. Kothare and P.A. Laux in Financial Analysts Journal (March/April 1995) 8 See “Competition and the Pricing of Dealer Service in the Over-the-Counter Market” by S.Tinic and R. West in Journal of Financial and Quantitative Analysis (June 1972), “The Pricing of Security Dealer Services: An Empirical Analysis of NASDAQ stocks” by H. Stoll in Journal of Finance (November 1978) and Jegadeesh, N. and A. Subrahmanyam, 1993, “Liquidity Effects of the Introduction of the S&P 500 Futures Contract on the Underlying Stocks” in Journal of Business (April 1993). V66, 171.187.

25

that variables such as price level, volatility and trading volume are not only correlated

with each other, but are also correlated with other variables such as firm size.

The study by Kothare and Laux, that looked at average spreads on the NASDAQ

also looked at differences in bid-ask spreads across stocks on the NASDAQ. In addition

to noting similar correlations between the bid-ask spreads, price level and trading

volume, they uncovered an interesting new variable. They found that stocks where

institutional activity increased significantly had the biggest increase in bid-ask spreads.

While some of this can be attributed to the concurrent increase in volatility in these

stocks, it might also reflect the perception on the part of market makers that institutional

investors tend to be informed investors with more or better information. Note, though,

that institutional investors also increase liquidity which should reduce the order

processing cost component of the bid-ask spread, and in some cases the net effect can

lead to a lower spread.9

Can firms have an effect on the bid-ask spreads that their stock trades at? There is

some evidence that they can by improving the quality of information that they disclose

the financial markets, thus reducing the advantages that informed traders may have

relative to the rest of the market. Heflin. Shaw and Wild (2001) look at 221 firms and

examine the relationship between information disclosure quality – they measure this

using disclosure quality scores assigned by the Corporate Information Committee of the

Financial Analysts Federation – and the bid-ask spread. They find that bid-ask spreads

decrease as information quality increases.10 Frost, Gordon and Hayes (2002) extend the

analysis to compare liquidity across different equity markets and find that markets with

strong disclosure systems also have the most liquidity.11

While most of the studies quoted above have looked at differences in spreads

across stocks, Hasbrouck (1991) investigated why spreads change for the same stock at

different points in time. He notes that large trades cause spreads to widen, relative to

9 Dey, M.K, and B. Radhakrishna, 2001, Institutional Trading, Trading Volume and Spread, Working Paper. They provide evidence of the link between institutional trading and the spread for stocks listed on the NYSE. 10 Heflin, F., K.W. Shaw and J.J. Wild, 2001, Disclosure Quality and Market Liquidity, Working Paper, SSRN. 11 Frost, C.A., E.A. Gordon and A.F. Hayers, 2002, Stock Exchange Disclosure and Market Liquidity: An Analysis of 50 International Exchanges, Working Paper, SSRN.

26

small trades, and hypothesizes that this is because large trades are more likely to contain

information.12

c. Price Impact

Studies of the price reaction to large block trades on the floor of the exchange

conclude that prices adjust within a few minutes to such trades. An early study examined

the speed of the price reaction by looking at the returns an investor could make by buying

stock right around the block trade and selling later13. They estimated the returns after

transactions as a function of how many minutes after the block trade you traded, and

found that only trades made within a minute of the block trade had a chance of making

excess returns. (See Figure 2) Put another way, prices adjusted to the liquidity effects of

the block trade within five minutes of the block. While this may be understated because

of the fact that these were block trades on large stocks on the NYSE, it is still fairly

strong evidence of the capacity of markets to adjust quickly to imbalances between

demand and supply.

12 Hasbrouck, J., 1991, Measuring the Information Content of Stock Trades, Journal of Finance, v46, 179-207; Hasbrouck, J., 1991, The Summary Informativeness of Stock Trades: An Economic Analysis, Review of Financial Studies, v4, 571-595. 13 Dann, L.Y., D. Mayers, and R. J. Rabb（1977）,Trading Rules, Large Blocks and the Speed of Price Adjustment, The Journal of Financial Economics, 4, 3-22.

27

Source: Dann, Mayers and Rabb (1977)

This study suffers from a sampling bias - it looks at large block trades in liquid

stocks on the exchange floor. Studies that look at smaller, less liquid stocks find that the

price impact tends to be larger and the adjustment back to the correct price is slower than

it is for the more liquid stocks.14 There are other interesting facts about block trades that

have emerged from other studies. First, while stock prices go up on block buys and go

down on block sells, they are far more likely to bounce back after sell trades. In other

words, when prices go up after a block buy, they are more likely to stay up.15 A study by

Spierdijk, Nijman, and van Soest (2002) that looked at both liquid and illiquid stocks on

the NYSE also finds a tendency on the part of markets to overshoot. When a block buy is

14 Joel Haasbrouck looked at a detailed data set that contained information on quotes, trades and spreads of stocks listed on the NYSE and came to this conclusion. 15 See Holthausen, R. W., R. W. Leftwich, and D. Mayers, 1990, Large-Block Transactions, the Speed of Response, and Temporary and Permanent Stock-Price Effects," Journal of Financial Economics, 26, 71-95. and Keim, D. B., and A. Madhavan, 1995, Anatomy of the Trading Process: Empirical Evidence on the Behavior of Institutional Trades," Journal of Financial Economics, 37, 371-398.

Figure 2: Annualized Returns from buying after block trades

-100%

-50%

0%

50%

100%

150%

0 1 5 10 15

Minutes after the Block Trade

An

nu

ali

zed

Retu

rn (

net

of

tran

sacti

on

s co

sts)

Block size =100K

Block size =50K

Block Size =10K

28

made, the price seems to go up too much and it can take several days for it to revert back

to a normal level for illiquid stocks.16

These studies, while they establish a price impact, also suffer from another

selection bias, insofar as they look only at actual executions. The true cost of market

impact arises from those trades that would have been done in the absence of a market

impact but were not because of the perception that it would be large. In one of few

studies of how large this cost could be, Thomas Loeb collected bid and ask prices from

specialists and market makers, at a point in time, for a variety of block sizes. Thus, the

differences in the spreads as the block size increases can be viewed as an expected price

impact from these trades. Table 1 summarizes his findings across stocks, classified by

market capitalization:

Table 1: Round-Trip Transactions Costs as a Function of Market Capitalization and

Block Size

Dollar Value of Block ($ thoustands)

Sector 5 25 250 500 1000 2500 5000 10000 20000

Smallest 17.30% 27.30% 43.80%

2 8.90% 12.00% 23.80% 33.40%

3 5.00% 7.60% 18.80% 25.90% 30.00%

4 4.30% 5.80% 9.60% 16.90% 25.40% 31.50%

5 2.80% 3.90% 5.90% 8.10% 11.50% 15.70% 25.70%

6 1.80% 2.10% 3.20% 4.40% 5.60% 7.90% 11.00% 16.20%

7 1.90% 2.00% 3.10% 4.00% 5.60% 7.70% 10.40% 14.30% 20.00%

8 1.90% 1.90% 2.70% 3.30% 4.60% 6.20% 8.90% 13.60% 18.10%

Largest 1.10% 1.20% 1.30% 1.71% 2.10% 2.80% 4.10% 5.90% 8.00%

The sectors refer to market capitalization, and show the negative relationship between

size and price impact. Note, however the effect of increasing block sizes on expected

price impact, within each sector; larger trades elicit much larger price impact than do

smaller trades.

Looking at the evidence, the variables that determine that price impact of trading

seem to be the same variables that drive the bid-ask spread. That should not be surprising. 16 Spierdijk, L., T. Nijman and A.H.O. Van Soest, 2002, The Price Impact of Trades in Illiquid Stocks in Periods of High and Low Market Activity, Working Paper, Tillburg University.

29

The price impact and the bid-ask spread are both a function of the liquidity of the market.

The inventory costs and adverse selection problems are likely to be largest for stocks

where small trades can move the market significantly. Breen, Hodrick and Korajczyk

(2000) studied both the magnitude of the price impact and its determinants by looking at

stocks listed on U.S. exchanges.17 They find that increasing the turnover by 0.1% in a 5-

minute interval can create a price impact of 2.65% for NYSE and AMEX firms and about

1.85% for NASDAQ stocks. Comparing the price impact across firms, they find evidence

of the following:

1. The price impact of a trade of a given number of shares is smaller for larger market cap

firms than for smaller firms. However, the price impact of a trade of the same percentage

magnitude (as a percent of market cap) is greater for larger market cap firms than for

smaller firms.

2. The price impact of a trade is smaller for firms with high trading volume in the

previous quarter and for firms that have positive momentum (i.e, stock price has gone up

in the six months prior to the trade).

3. The price impact of a trade is smaller for firms with high institutional holdings (as a

percent of outstanding stock) than for a firm with lower institutional holdings.

Other Assets

The evidence on cross sectional differences in transactions costs is much lighter in

markets other than US stocks, but there have been attempts made to quantify differences

within asset classes in other markets.

Bonds

As we noted earlier, the US treasury security market is extremely liquid, but

within that market, the most traded (and liquid) securities tend to be the most recently

issued treasuries with standard maturities: the 3-month and 6-month treasury bills, the 1-5

year treasury notes and the 10-year treasury bond. Liquidity tends to drop off for

seasoned treasuries with non-standard maturities, but even with the decline, the

transactions costs are low. The corporate bond market is characterized by much wider

17 Breen, W.A., L.S. Hodrick and R.A. Korjczyk, 2000, Predicting Equity Liquidity, Working Paper, Kellogg Graduate School of Management.

30

differences in liquidity. A study that looked at all over the counter bond market trades

between 2003 and 2005 concluded that highly rated bonds, recently issued bonds and

bonds close to maturity are more liquid and have lower transactions costs.18 In addition,

the study also found that bonds with transparent trade prices tend to be more liquid than

bonds where prices are not public and visible.19

Real Estate and other real assets

With real estate, you would expect illiquidity to be more of a problem in those

geographical areas where there has been overbuilding and thus an imbalance between

buyers and seller, and to decrease as institutional investors become a larger segment of

the market. Empirically, one statistic that we referenced earlier – days on market (DOM)

- suggests that there are wide differences in liquidity across segments of the real estate

not only by region, but also for different types of property. In November 2010, for

instance, single-family homes in Fairbanks, Alaska, had spent an average of 62 days on

the market whereas single-family homes in Scottsdate, Arizona, reported being on the

market for 164 days, on average. At the same point in time, residential real estate has

been on the market longer than commercial real estate in Fairbanks but the reverse was

true in Scottsdale.

The evidence from other real asset markets on liquidity is primarily anecdotal,

though the opening up of online auction sites has opened provided new data for

researchers. For instance, liquidity is greater for those lower-priced collectibles where a

third party exists to provide a stamp of authenticity; baseball cards can be graded on

quality by expert services before being put online for sale. In contrast, liquidity is a much

greater concern for expensive artwork, where each piece of art has to be individually

assessed and analyzed.

18 Edwards, A.K., L.E. Harris and M.S. Piwowar, 2007, Corporate Bond Market, Transparency and Transactions Costs, Journal of Finance, v62, 1421-1451. 19 Unlike the stock market, bond dealers provide public quotes for only a few bonds and bond transaction prices are not published. In 2002, the National Association of Security Dealers (NASD) required dealers to report all OTC bond transactions on TRACE (Trade Reporting and Compliance Engine). The study compared the liquidity of bonds whose prices were made public through this system with bonds where the prices were not reported.

31

Across time

Just as liquidity can vary across assets within a market, it can vary over time for

the entire market. As the banking crisis of 2008 illustrated, even the most liquid markets

can become illiquid for periods of time, creating significant costs for investors who need

or want to exit the market during those periods. Much of the research on time varying

liquidity has come from studies on publicly traded stocks for two reasons. First, there is a

long history that can be examined, especially in the United States. Second, illiquidity can

be measured using observable variables such as the bid ask spread or trading volume over

time. In this section, we will begin by focusing on long term trends in liquidity, primarily

in equity markets, then look at short term interruptions created by crises and end with an

assessment of how regulatory and tax policy can affect liquidity.

Long term trends

As financial markets have evolved and grown over the last century, the trend has

been towards more liquidity. This increase in liquidity can be measured on many

dimensions.

a. Listed and traded securities: In the early part of the twentieth century, there were

relatively few companies that had publicly traded, listed stock and these

companies represented a small percentage of the economy. In 1926, for instance,

there were about 500 companies listed on the US exchanges, whereas in 2010,

there were more than 7000 listed companies in the United States, traded on

several exchanges and over the counter. In emerging markets, the increase in

listings has been explosive especially in the last two decades. The number of

publicly listed companies in India, for instance, increased from 4344 in 1985 to

8593 in 2010.

b. Investor base: When equity markets were developing in the United States, they

primarily attracted money from wealthy individuals. As access to markets

improved, the investor base has widened and most individuals in the US, with any

savings, have some exposure to equity markets, either because of direct

investments in individual stocks or holdings of mutual funds. Equity markets

32

outside the United States have also seen a similar influx of new investors and

often over a much shorter time span.

c. Breadth and Depth of trading: As more companies get listed and more people

invest in markets, it is inevitable that trading volume will increase and it has in

most markets. Not only has aggregate volume (measured in dollar value)

increased over time in the US equity market, but so have turnover ratios. In

summary, investors are not only trading shares in more companies, but they are

also trading these shares more often than they used to.

Not surprisingly, as trading volume has increased and more investors trade, transactions

costs have decreased. Jones (2002), for instance, examines bid-ask spreads and

transactions costs for the Dow Jones stocks from 1900 to 2000 and figure 3 presents his

findings:

Figure 3: Average Dollar Spread – Dow Jones: 1900 - 2000

Note that the transactions costs are much lower today than they were in the early 1900s

and that this may account for the lower equity risk premium in recent years.20

Within these long term trends, though, are cyclical movements, where liquidity

ebbs and flows. In stock markets, volume tends to increase during long-term bull markets

20 This becomes clear when we look at forward-looking or implied equity risk premiums rather than historical risk premiums. The premiums during the 1990s averaged about 3%, whereas there were more than 5% prior to 1960. Jones, C.M., 2002, A Century of Stock Market Liquidity and Trading Costs, Working Paper, Columbia University.

33

and dampen during long term bear markets. It is in the real estate market that liquidity

cycles are accentuated, with transactions surging in “hot” markets and dropping in “cold”

markets. In conjunction, the waiting time to sell property, measured as days on the

market (DOM) increases during cold markets. Figure 4 reports on the percentage of the

properties in one real estate index (NCREIF) each year and the percentage change in

property values from 1983 to 2003:

Figure 4: Liquidity and Market Movements: Real Estate

Note the drop in transactions occurs in periods where real estate property values also

drops, reflecting the fact that real estate owners often hold back properties, waiting for a

better time to sell.

Effects of market crises

While the long-term trend in financial markets has been towards more trading and

liquidity, with concurrent increases in volume and decrease in transactions costs, there

have been periods of illiquidity in every market. These periods have generally coincided

with market crises of one kind or the other, with the following distortions appearing in

their midst:

a. Order imbalances and trading halts: During crisis, sudden shifts in demand and

supply can create order imbalances, with most of the orders coming in on one side of

34

the ledger. To provide an example, the S&P 500 lost more than 20% of its value on

October 19, 1987. On the same day, the much riskier NASDAQ lost only 11.3%, but

only because trading was halted on 195 of the 2257 stocks on the index on that day.

During the last quarter of 2008, trading halts occurred frequently even on large

market cap companies, as a result of demand supply imbalances.

b. Increase in bid-ask spreads: When illiquidity rises during crises, bid-ask spreads

change as well. The average bid-ask spread on large market cap US stocks increased

substantially between September 12, 2008 and the end of that year, primarily as

markets melted down and liquidity became more of an issue (see figure 5)

Figure 5: Bid-ask spreads for US stocks – Effects of 2008 Crisis

Note the surge in bid-ask spreads starting in September 2008 through the end of the

crisis in December 2008. Concurrently, stock price volatility as measured by the

Volatility Index (VIX) surged, as did the bond default spread, measured as the

difference between the LIBOR and treasury bills.

c. Increase in price impact: As order imbalances and bid-ask spreads increase, investors

face a much bigger price impact when they trade on stocks. During the crisis of 2008,

this was manifested in one of two ways. Large volume trades in either direction (buys

or sells) were accompanied by large changes in prices, even for the most liquid

market cap companies. In at least one company, Volkswagen, the absence of

35

illiquidity created a short squeeze in the last week of October 2008, where investors

who had sold short on the stock were unable to buy shares to cover their positions,

resulting in an explosive rise of 245% in the stock price of the company, making it

briefly the largest market cap company in the world(see figure 6):21

Figure 6: Volkswagen Short Squeeze: October 2008

In summary, the crisis of 2008 served as a reminder that while financial markets, for the

most part, are more liquid than they were several decades ago, that liquidity is more

fragile than we thought it to be. While liquidity did return to markets after the crisis, there

were several months during and after the crisis where investors trying to liquidate

positions in equity or bond markets faced substantial trouble (and cost) in doing so.

Regulatory, Legal and Tax Effects

Regulatory and legal events can have significant effects on market liquidity. With

US equities, for instance, we can point to two regulatory shifts that impacted transactions

costs substantially. The first was the ending of fixed commissions in stock trading in

1975, which opened up the trading game, allowing new brokerage services to compete 21 The short squeeze was triggered by Porsche, which was a large holder of Volkswagen stock, unexpected increasing its holding of the stock (when it was expected to reduce it).

36

with established equity brokers. As a result, brokerage costs dropped dramatically in the

United States. The second was in the mid-nineties, when the NASDAQ, under pressure

from regulators, moved to decimalization from the old quote system (which moved in

1/16 increments) and transactions costs dropped in the aftermath.

Not all regulatory and legal changes have had positive impact on liquidity. During

market crises, regulatory authorities have often responded to panicked trading by putting

restrictions on trading. While usually well intentioned, these restrictions often affect

liquidity adversely. During the banking crisis of 2008, for instance, regulators banned

short selling on a selected list of financial service companies that they believed were

being targeted by speculators. Figure 7 below summarizes the effect on the bid-ask

spreads of these companies and contrasts that with the bid-ask spreads of companies that

were not covered by the short sales ban.

Figure 7: Short Sales Bans and Bid Ask Spreads

Note that the bid-ask spreads of companies, with short sales bans, increased much more

during the crisis than the bid-ask spreads of companies not subject to the ban.

Tax policy can also affect liquidity. A tax imposed on financial transactions, for

instance, will reduce trading and can be viewed as an added transactions cost. Umlauf

(1993) examined the impact of an increase in the transactions tax rate from 1% to 2% in

Sweden in 1986 and found a drop in trading volume of 30% in the market in the

37

aftermath, as trading migrated to other markets.22 If the tax rate paid on investment

profits is a function of holding period, it can affect whether and how much investors

transact. The presence of a capital gains tax rate, where price appreciation gets taxed

when an asset is sold for a price higher than it originally cost, but only if it is held for

more than 6 months, will lead to investors to defer sales of their best-performing

investments.

The cost of illiquidity As the last section makes clear, liquidity, measured in term of volume and

transactions costs, can vary across markets, across assets within each market and across

time. But how much do investors care about this liquidity? In this section, we will not

only present evidence that investors do factor liquidity into pricing decisions, but we will

also argue that the cost of illiquidity will vary across time.

Across assets within an asset class

One approach to evaluating how much investors care about illiquidity is to look at

how they price assets within the same market, given the differences in liquidity. In the

sections below, we will first review the evidence from the bond market and then look at

the much richer data in the stock market.

Bonds

Liquidity can vary across bonds issued by different entities, and across maturities,

for bonds issued by the same entity. These differences in liquidity offer us an opportunity

to examine whether investors price liquidity and if so, how much, by comparing the

yields of liquid bonds with otherwise similar illiquid bonds. Studies of bond market

liquidity have looked at the treasury bond, corporate bond and subordinated bond

markets.

• Treasury Bills/Bonds: Amihud and Mendelson (1991) compared the yields on

treasury bonds with less than six months left to maturity with treasury bills that have

the same maturity.23 They concluded that the yield on the less liquid treasury bond

22 Umlauf, Steven R., 1993, Transaction taxes and the behavior of the Swedish stock market, Journal of Financial Economics 33, 227-240. 23 Amihud, Y., and H. Mendelson, 1991, Liquidity, Maturity and the Yield on U.S. Treasury Securities,

38

was 0.43% higher on an annualized basis than the yield on the more liquid treasury

bill, a difference that they attributed to illiquidity. A subsequent study by Kamara

(1994) confirmed their finding and concluded that the yield difference was 0.37%.24

Strebulaev (2002) contests their finding, noting that the tax treatment on bonds varies

from the tax treatment of treasury bills and that this may explain the difference in

yields. He compares treasury notes maturing on the same date and concludes that they

trade at essentially identical prices, notwithstanding big differences in liquidity.25

• Corporate bonds: Chen, Lesmond and Wei (2005) compared over 4000 corporate

bonds in both investment grade and speculative categories, and concluded that illiquid

bonds had much higher yield spreads than liquid bonds. To measure liquidity, they

used multiple measures including the bid-ask spread, the occurrence of zero returns in

the time series26 and the LOT measure (which incorporates the bid-ask spread,

opportunity costs and price impact). Not surprisingly, they find that liquidity

decreases as they move from higher bond ratings to lower ones and increases as they

move from short to long maturities. Comparing yields on these corporate bonds, they

conclude that the yield increases 0.21% for every 1% increase in transactions costs

for investment grade bonds, whereas the yield increases 0.82% for every 1% increase

in transactions costs for speculative bonds.27

• Subordinated bonds: A study of 211 subordinated bonds issued by 22 large banks in

the United States concluded that more illiquid bonds trade at higher default spreads

than otherwise similar liquid bonds.28 They find that bonds that have not traded

within the last six months have a default spread that is about 0.20% higher than traded

Journal of Finance, 46, 1411-1425. 24 Kamara, A., 1994, Liquidity, Taxes, and Short-Term Yields, Journal of Financial and Quantitative Analysis, 29, 403-417. 25 Strebulaev, I., 2002, Liquidity and Asset Pricing: Evidence from the US Treasuries Market, Working Paper, London Business School. 26 When an asset does not trade during a period, the return will be zero during the period. Counting the number of zero return periods can provide one proxy for illiquidity. 27 Chen, L., D.A. Lesmond and J. Wei, 2005, Corporate Yield Spreads and Bond Liquidity, Working Paper, SSRN. 28 Bianchi, C., D. Hancock and L. Kawano, 2004, Does Trading Frequency affect Subordinated Debt Spreads? Working Paper, Federal Reserve Bank, Washington D.C. To measure liquidity, they consider whether a “generic price” is available on Bloomberg for a bond. Since a generic price is available only when a bond trades, it becomes a proxy for liquidity with more liquid bonds having more generic prices listed for them.

39

bonds , and that this spread widens out to 0.64% when the bond has not traded in the

last two years.

Looking across the studies, the consensus finding is that liquidity matters for all bonds,

but that it matters more with risky bonds than with safer bonds. This may explain why the

prevalence of a liquidity premium in the government bond market is debatable but not in

the corporate bond market.

Stocks

Studies of illiquidity in the equity market have run the gamut ranging from those

examining differences in liquidity across stocks and how these differences translate into

differences in expected returns, to more focused studies, that try to find a subset of stocks

where illiquidity is an issue and then measure how investors react to that illiquidity.

Differences across stocks

Some stocks are more liquid than others and the consensus conclusion is that

investors demand higher returns when investing in more illiquid stocks. Put another way,

investors are willing to pay higher prices for more liquid investments relative to less

liquid investments.

The first set of evidence that liquidity matters and is priced in by investors is largely

circumstantial. While it would be foolhardy to attribute all of the well documented excess

returns29 that have been associated with owning small market capitalization and low price

to book stocks to illiquidity, smaller and more distressed companies (which tend to trade

at low price to book ratios) to liquidity differences, it cannot be coincidence that these are

among the most illiquid companies in the market. The interplay between illiquidity and

so many observed inefficiencies in the market suggests that it plays a key role in how

investors price stocks and the returns that we observe in the aftermath. It may also

explain why there are so many ways of making excess returns on paper and so few in

practice.

The other strand of research links liquidity more directly to returns, by using

measures of liquidity to explained differences in stock returns over long time periods.

Amihud and Mendelson (1989) examined whether adding bid-ask spreads to betas helped 29 Fama, E.F. and K.R. French, 1992, The Cross-Section of Expected Returns, Journal of Finance, v47, 427-466.

40

better explain differences in returns across stocks in the U.S.30 In their sample of NYSE

stocks from 1961-1980, they concluded that every 1% increase in the bid-ask spread (as a

percent of the stock price) increased the annual expected return by 0.24-0.26%. Eleswarapu (1997) confirmed this finding by showing a positive relationship between returns and spreads for Nasdaq stocks.31 Other studies have used trading volume,

turnover ratios (dollar trading volume/ market value of equity) and illiquidity ratios as

proxies for illiquidity with consistent results. Brennan and Subrahmanyan(1996) break

transactions costs down into fixed and variable costs and find evidence of a significant

effect on returns due to the variable cost of trading after controlling for factors such as

firm size and the market to book ratio.32 Brennan, Chordia and Subrahmanyam (1998)

find that dollar trading volume and stock returns are negatively correlated, after adjusting

for other sources of market risk.33 Datar, Nair and Radcliffe (1998) use the turnover ratio

as a proxy for liquidity. After controlling for size and the market to book ratio, they

conclude that liquidity plays a significant role in explaining differences in returns, with

more illiquid stocks (in the 90the percentile of the turnover ratio) having annual returns

that are about 3.25% higher than liquid stocks (in the 10th percentile of the turnover ratio).

In addition, they conclude that every 1% increase in the turnover ratio reduces annual

returns by approximately 0.54%.34 Amihud (2002) developed a measure of illiquidity by

dividing the absolute price change by the average daily trading volume for the stock to

estimate an illiquidity ratio and concluded that stock returns are positively correlated with

this measure.35 Nguyen, Mishra and Prakash (2005) conclude that stocks with higher

30 Amihud, Y. and . Mendelson, 1989, the Effects of Beta, Bid-Ask Spread, Residual Risk and Size on Stock Returns, Journal of Finance, v 44, 479-486. 31 Eleswarapu, V.R. 1997, Cost of transacting and expected returns in the Nasdaq Market, Journal of Finance, 52 (5), 2113-2127. There are other studies that find a weaker or no relationship between stock returns and bid-ask spreads. Chalmers and Kadec use the amortized spread and find no relationship between spreads and returns for NYSE stocks. Chalmers, J.M.R. and G.B. Kadlec, 1998, An Empirical examination of the Amortized Spread, Journal of Financial Economics, 48 (2), 159-188. 32 Brennan, M. J. and A. Subrahmayam, 1996, “Market microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns,” Journal of Financial Economics 41, 441-464. 33 Brennan, M. J., T. Chordia, and A. Subrahmanyam, 1998. Alternative factor specifications,security characteristics and the cross-section of expected stock returns, Journal of Financial Economics, 49, 345–373. 34 Datar, V.T., N. Y. Naik and R. Radcliffe, 1998, “Liquidity and stock returns: An alternative test,” Journal of Financial Markets 1, 203-219. 35 Amihud, Y., 2002, Illiquidity and stock returns: Cross-section and time-series effects, Journal of Financial Markets 5, 31-56.

41

turnover ratios do have lower expected returns. They also find that market capitalization

and price to book ratios, two widely used proxies that have been shown to explain

differences in stock returns, do not proxy for illiquidity.36

There are a few studies that focus on subsets of the market to examine the effects of

liquidity and pricing and arrive at the same conclusions: liquidity matters and investors

price them in. For instance, Ellul and Pagano (2002) related the underpricing of 337

British initial public offerings to the illiquidity of the issues after the offerings, and found

evidence that the less liquid shares are expected to be and the less predictable the

liquidity, the greater the under pricing.37

Differences across Control Groups

Studies that compare stocks with different liquidity can always be faulted for not

controlling for other factors. After all, companies with more liquid stocks tend to have

larger market capitalization and lower risk. Consequently, the cleanest tests for illiquidity

are those that compare stocks with different degrees of liquidity issued by the same

company. Differences in stock prices can then be attributed purely to liquidity.

a. Restricted stock: Much of the evidence on illiquidity discounts comes from examining

“restricted stock” issued by publicly traded firms. Restricted securities are securities

issued by a publicly traded company, not registered with the SEC, and sold through

private placements to investors under SEC Rule 144. They cannot be resold in the open

market for a one-year holding period38, and limited amounts can be sold after that. When

this stock is issued, the issue price is set much lower than the prevailing market price,

which is observable, and the difference can be viewed as a discount for illiquidity. The

results of two of the earliest and most quoted studies that have looked at the magnitude of

this discount are summarized below:

36 Ngyuen, D., S. Mishra and A.J. Prakash, 2005, On Compensation for Illiquidity in Asset Pricing: An Empirical Evaluation using the Three-factor Model and the Three-moment CAPM, Working Paper, SSRN. 37 Ellul, A. and M. Pagano, 2002, IPO Underpricing and After-market Liquidity, Working Paper, SSRN. 38 The holding period was two years prior to 1997 and has been reduced to one year since.

42

• Maher examined restricted stock purchases made by four mutual funds in the period

1969-73 and concluded that they traded an average discount of 35.43% on publicly

traded stock in the same companies.39

• Silber examined restricted stock issues from 1981 to 1988 and found that the median

discount for restricted stock is 33.75%.40 He also noted that the discount was larger

for smaller and less healthy firm, and for bigger blocks of shares.

Other studies confirm these findings of a substantial discount, with discounts ranging

from 30-35%. One more recent study by Johnson (1999) did find a smaller discount of

20%.41 These discounts suggest a large cost to illiquidity, but there are reasons to be

skeptical. First, these studies are based upon small sample sizes, spread out over long

time periods, and the standard errors in the estimates are substantial. Second, most firms

do not make restricted stock issues and the firms that do make these issues tend to be

smaller, riskier and less healthy than the typical firm. This selection bias may be skewing

the observed discount. Third, the investors with whom equity is privately placed may be

providing other services to the firm, for which the discount is compensation. One way of

isolating the service difference would be to compare unregistered private placements,

which represent the restricted stock issues, to registered private placements of equity by

companies. Since only the former have restrictions on marketability, the difference in

discounts between the two may be a better measure of the illiquidity discount. Wruck

(1989) made this comparison and estimated a difference of 17.6% in average discounts

and only 10.4% in the median discount between the two types of placements.42 Hertzel

and Smith (1993) expanded on this comparison of restricted stock and registered private

placements by looking at 106 private placements of equity from 1980 to 1987.43 They

concluded that while the median discount across all private placements was 13.26%, the

39 Maher, J.M., 1976, Discounts for Lack of Marketability for Closely Held Business Interests, Taxes, 54, 562-571. 40 Silber, W.L., 1991, Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices, Financial Analysts Journal, v47, 60-64. 41 B. A. Johnson,1999, Quantitative Support for Discounts for Lack of Marketability, Business Valuation Review, v16, 152-55 . 42 Wruck, K.H., 1989, Equity Ownership Concentration and Firm Value: Evidence from Private Equity Financings, Journal of Financial Economics, 23. 3-28. She concluded that a significant portion of the discount could be attributed to control changes at the firms. 43 Hertzel, M. and R.L. Smith, 1993, Market Discounts and Shareholder Gains from Placing Equity Privately, Journal of Finance, v48, 459-486.

43

discount was 13.5% higher for restricted stock than for registered stock. Bajaj, Dennis,

Ferris and Sarin (2001) looked at 88 private placements from 1990 to 1997 and report

median discounts of 9.85% for registered private placements and 28.13% for restricted

stocks. After controlling for differences across the firms making these issues, they

attribute only 7.23% to the illiquidity discount.44

b. Companies with multiple share classes: Some companies have multiple classes of

shares traded, with some classes being more liquid than others. If there are no other

differences (in voting rights or dividends, for instance) across the classes, the difference

in prices can be attributed to liquidity. In the Chinese market, for instance, most

companies have Restricted Institutional Shares (RIS) which are illiquid45 and common

shares which are traded on the exchange. Chen and Xiong (2001) compare the market

prices of the traded common stock in 258 Chinese companies with the auction and private

placement prices of the RIS shares and conclude that the discount on the latter is 78% for

auctions and almost 86% for private placements.46 This astoundingly high discount,

which they attributed to illiquidity, does vary across firms, with smaller discounts at

larger, less volatile firms. In a different vein, researchers have compared the stock prices

of Class A and Class B shares of Chinese companies. The former are open only to

Chinese investors, whereas the latter can be bought by both domestic and foreign

investors. While they both offer the same claims on the cashflows, Class B shares trade at

a significant discount on Class A shares. The differences, though, seem to be only

partially attributable to differences in liquidity and seem more due to differential

information.47

44 Bajaj, M., D.J. Dennis, S.P.Ferris and A.Sarin, 2001, Firm Value and Marketability Discounts, Journal of Corporate Law, v27. 45 Restricted Institutional Shares have to be transacted through private placements. Starting in August 2000, the Chinese Government has also allowed for auctions of these shares, where it is presumably a little easier to find a potential buyer. 46 Chen, Z. and P. Xiong, 2001, Discounts on Illiquid Stocks: Evidence from China, Working Paper, Yale University. 47 Wang, S.S. and L. Jiang, 2003, Location of Trade, Ownership Restrictions, and Market Illiquidity: Examining Chinese A- and H-Shares, Working Paper, Hong Kong Polytechnic University. Chan, K., A.J. Menkveld and Z. Yang, 2002, Evidence of the Foreign Share Discount Puzzle in China: Liquidity or Information Asymmetry, Working Paper, National Center for Economic Research, Tsinghua University.

44

Across time

When market liquidity increases, you should expect to see an increase in asset

prices accompanied by a drop in the return you would require that asset to make; the

difference between this expected return and the risk free rate is the risk premium for that

asset class. In the equity market, some of the risk premium attributed to equity can be

attributed to liquidity costs. In the last section, we referenced a study by Jones that looks

at transactions costs on the Dow 30 stocks over time and notes a decline in the cost. That

study also presents evidence that increases in the bid-ask spread and lower turnover are

harbingers of higher stock returns in the future, which he takes as evidence that illiquidity

is a factor behind both the magnitude of and changes in the equity risk premiums. His

research is in line with others who have argued that variations in liquidity (and the

associated costs) over time may explain a portion of the shifts in the equity risk premium

from period to period. In the bond market, as investors become more concerned about

illiquidity, they will demand higher interest rates and default spreads. In figure 8, we

graph the implied equity risk premium for the US market, extracted from the index level

and expected cash flows, and the default spread on a Baa bond from 1960 to 2010.

45

Both the equity risk premium and the Baa default spread vary over time, though the

variation can be attributed to a multitude of factors: changing risk aversion, uncertainty

about the economy, fear of catastrophe and illiquidity. Some of the variation can be

attributed to illiquidity and it intuitively makes sense that investors care more about

liquidity (or its absence) in some periods than others, and charge a higher price for it.

Across investors

While all investors care about liquidity, not all of them care about it to the same

extent. There are at least four factors that come into play in determining the cost attached

to illiquidity:

• Time horizon: Investors with shorter time horizons will be more negatively affected

by illiquidity than investors with longer time horizons, for the simple reason that they

are more exposed to that cost. If you turn your portfolio over twice a year, you will

incur much more in transactions costs than if you turn your portfolio ten times a year.

• Investment philosophy: Momentum investors who trade on information will face

larger costs from illiquidity than contrarian investors trading on value.

• Type of assets held: As liquidity changes at the market wide level, the effects are

likely to be much greater for assets that were relatively illiquid to begin with. Thus, a

fund that invests in small companies or privately owned businesses is likely to face a

much larger cost from increased illiquidity than one that invests in large market cap

companies.

• Financial leverage: Investment strategies that are more dependent upon borrowing

money will be more exposed to illiquidity costs, because it will represent a higher

percentage of the value of equity in the portfolio. A 5% impact on the price of an

asset, funded with 80% debt, translates into a 25% loss in equity value.

During the banking crisis of 2008, there were hedge funds that were forced into

liquidation or pushed to the precipice by illiquidity in the market. Many of these funds

invested in lightly traded assets, where the illiquidity costs were highest, had impatient or

nervous investors who wanted to cash out and used debt liberally. In fact, illiquidity

create a vicious feedback loop at these funds, where poor returns on investments

46

precipitate cash withdrawals by fund investors, which triggers more asset sales at

discounts, which triggers worse returns, which trigger more withdrawals and so on.

If the cost of illiquidity varies across investors, it follows that there should be a

potential for profit on the part of those investors whose liquidity profiles don’t match the

norm. Put in less abstract terms, a long term value investor, who cares little about

liquidity, will be a buyer during a liquidity crisis. This “liquidity arbitrage” will be most

profitable when markets become less liquid and the cost of illiquidity rises, since

investors who care about illiquidity will mark prices down to levels that make them

attractive to investors who do not. To provide an example, during the market crisis of

2008, Warren Buffett made well-publicized investments in Goldman Sachs and GE,

when these big-name firms were confronted with illiquidity problems. While those

investments were not riskless – the market could have melted down- they have paid off

handsomely as liquidity has returned to markets and health to the companies.

Privately held assets

If investors attach a cost to illiquidity at publicly traded investments, in crisis

periods, it stands to reason that they will charge an even higher cost for investments that

are not publicly traded. In most cases, though, it is difficult to quantify this cost because

the observed transactions price already reflects the illiquidity discount. In this section, we

will look at private equity, real estate and private business appraisals for clues on how

much investors value liquidity.

Private Equity

Private equity and venture capital investors often provide capital to private

businesses in exchange for a share of the ownership in these businesses. Implicit in these

transactions must be the recognition that these investments are not liquid. If private

equity investors value liquidity, they will discount the value of the private business for

this illiquidity and demand a larger share of the ownership of illiquid businesses for the

same investment. Looking at the returns earned by private equity investors, relative to the

returns earned by those investing in publicly traded companies, should provide a measure

of how much value they attach to illiquidity.

47

Ljungquist and Richardson (2003) estimate that private equity investors earn

excess returns of 5 to 8%, relative to the public equity market, and that this generates

about 24% in risk-adjusted additional value to a private equity investor over 10 years.

They interpret it to represent compensation for holding an illiquid investment for 10

years.48 Das, Jagannathan and Sarin (2003) take a more direct approach to estimating

private company discounts by looking at how venture capitalists value businesses (and

the returns they earn) at different stages of the life cycle. They conclude that the private

company discount is only 11% for late stage investments but can be as high as 80% for

early stage businesses.49 Franzoni, Nowak and Phalippou (2009) look at 3421 liquidated

private equity investments between 1981 and 2000 and conclude that investors in private

equity funds price in this liquidation risk by demanding premiums of up to 15% for

investing in these funds.50 However, there are perils in concluding that these discounts

are for marketability. In addition to illiquidity, private equity investors often are not

diversified and some of the additional return may represent a premium for this non-

diversification. In addition, private equity investors also exercise some or even significant

control over the firms they invest in, and the higher payoff may reflect the value of this

control.

Privately owned businesses

While it may be difficult to back out illiquidity discounts from transactions prices

for private businesses, there are indications that investors demand and get large illiquidity

discounts at these businesses. Here is some evidence:

a. Appraisal practices: The standard practice in many private company valuations is to

either use a fixed illiquidity discount for all firms or, at best, to have a range for the

discount, with the analyst’s subjective judgment determining where in the range a

particular company’s discount should fall. The genesis for these fixed discounts

seems to be in the studies of restricted stock that we noted in the last section. These

48 Ljungquist, A. and M. Richardson, 2003, The Cashflow, Return and Risk Characteristics of Private Equity, Working Paper, Stern School of Business. 49 Das, S., M. Jagannathan and A. Sarin, 2002, The Private Equity Discount: An Empirical Examination of the Exit of Venture Capital Companies, Working Paper, SSRN. 50 Franzoni, F., E. Nowak and L. Phallippou, 2009, Private Equity and Liquidity Risk, Working Paper, University of Lugano.

48

studies found that restricted (and therefore illiquid) stocks traded at discounts of 25-

35%, relative to their unrestricted counterparts, and private company appraisers have

used discounts of the same magnitude in their valuations.51 Since many of these

valuations are for tax court, we can see the trail of “restricted stock” based discounts

littering the footnotes of dozens of cases in the last three decades.52

b. Comparison of private to public transactions prices: One way to measure the

illiquidity discount attached to private companies is to compare the prices at which

private businesses are sold relative to the prices at which publicly traded companies

trade at. Koeplin, Sarin and Shapiro (2000) provide an illustration of this approach by

comparing the multiples paid for 84 private companies that were acquisition targets to

the multiples of earnings paid for 198 “similar” publicly traded firms between 1984

and 1998.53 Figure 9 shows the average multiples of earnings, book value and sales

for private and public firms:

51 In recent years, some appraisers have shifted to using the discounts on stocks in IPOs in the years prior to the offering. The discount is similar in magnitude to the restricted stock discount. 52 As an example, in one widely cited tax court case (McCord versus Commissioner, 2003), the expert for the taxpayer used a discount of 35% that he backed up with four restricted stock studies. 53 The multiples they used were all based upon enterprise value (market value of equity + debt – cash) in the numerator. They compared enterprise value to EBIT, EBITDA, Sales and the Book Value of Capital. Koeplin, J., A. Sarin and A. Shapiro, 2000, The Private Company Discount, Journal of Applied Corporate Finance, v12.

49

Note that, with the exception of revenue multiples, the private companies were acquired

at multiples about 20-30% lower than those paid for publicly traded firms; the discount

was larger (40-50%) for foreign private firms. The authors do note that notwithstanding

their attempts to get a controlled sample, the private companies in their sample were

smaller and had higher growth rates than the publicly traded companies.

Consequences of Illiquidity If markets are illiquid, we have to adapt both portfolio theory and corporate

finance to reflect this reality. In this section, we will examine how high transactions costs

and the inability to trade can alter the way in which we approach valuation, asset

allocation, security selection and corporate financial decisions.

Asset Pricing and Valuation

In an earlier section, we noted how both discounted cash flow valuation and

relative valuation pays scant attention to illiquidity. If illiquidity is a significant problem,

it behooves us to incorporate its effects more systematically into valuations.

0 2 4 6 8 10 12 14 16 18

EV/EBIT

EV/EBITDA

EV/Revenues

EV/Book Value

Figure 9: Private versus Public Acquisitions

Private companies Publicly traded companies

Publicly traded companies 16.39 10.15 2.86 1.32

Private companies 11.76 8.08 2.35 1.35

EV/EBIT EV/EBITDA EV/Revenues EV/Book Value

50

Intrinsic Valuation

The notion that investors will pay less for illiquid assets than for otherwise similar

liquid assets is neither new nor revolutionary. Over the last two decades researchers have

considered two ways of incorporating the effect of illiquidity into value. In the first, the

value of an asset is reduced by the present value of expected future transactions costs,

thus creating a discount on value. In the second, the required rate of return (discount rate)

on an asset is adjusted to reflect its illiquidity, with higher required rates of return (and

lower values) for less liquid assets.

One solution: A post-valuation discount

While most analysts accept the proposition that illiquid assets should be valued

lower than otherwise similar, more liquid assets, they are reluctant to incorporate the

illiquidity effects into valuation inputs: cash flows and discount rates. Instead, they adopt

standard valuation models that ignore illiquidity to value assets and discount that value at

the last stage for illiquidity.

The theory

Assume that you are an investor trying to determine how much you should pay for

an asset. In making this determination, you have to consider the cashflows that the asset

will generate for you and how risky these cashflows are to arrive at an estimate of

intrinsic value. You will also have to consider how much it will cost you to sell this asset

when you decide to divest it in the future. In fact, if the investor buying it from you builds

in a similar estimate of transactions cost she will face when she sells it, the value of the

asset today should reflect the expected value of all future transactions costs to all future

holders of the asset. This is the argument that Amihud and Mendelson used in 1986,

when they suggested that the price of an asset would embed the present value of the costs

associated with expected transactions costs in the future.54 In their model, the bid-ask

spread is used as the measure of transactions costs and small spreads can translate into

big illiquidity discounts on value. The magnitude of the discount will be a function of

investor holding periods and turnover ratios, with shorter holding periods and higher

turnover associated with bigger discounts. Vayanos (1998) argues that the effect of 54 Amihud, Y. and H. Mendelson, 1986, Asset Pricing and the Bid-ask Spread, Journal of Financial Economics, v 17, 223-250.

51

changes in transactions costs on asset prices is much smaller than estimated by Amihud

and Mendelson because investors adjust holding periods to reflect transactions costs. In

fact, he argues that the price of a stock can actually increase as its transactions costs

increase, especially for more frequently traded stocks; the increase in holding periods can

offset the transactions costs increase.55

Jarrow and Subramanian (2001) present an alternate model for estimating the

illiquidity discount on value.56 They model the discount as the difference between the

market value of an asset and its value when liquidated and argue that the discount should

be larger when there are execution lags in liquidation. They derive optimal trading rules

and the magnitude of the illiquidity discount for investors with power utility functions.

Lo, Mamaysky and Wang (2001) assume fixed transactions costs and conclude, like

Amihud and Mendelson, that small trading costs can create significant illiquidity

discounts and that these discounts are influenced heavily by the risk aversion of

investors.57

In summary, the studies that develop theoretical models for illiquidity discounts

all link them to expected transactions costs on assets but require investor holding periods

as an input for estimating the magnitude of the discount. The discount for any given

transaction costs will be smaller if investors have long time horizons than if they have

short time horizons.

In practice

In conventional valuation, the cashflows are expected cashflows, the discount rate

is usually reflective of the risk in the cashflows and the present value we obtain is the

value for a liquid business. As we noted earlier, appraisers of private businesses are

explicit about discounting their estimated values for illiquidity, often applying discounts

of 20% or higher to arrive at their final estimate. However, analysts valuing publicly

traded companies make no such adjustment, thus implicitly assuming that illiquidity is

not a large enough concern to affect value. Much of the theoretical and empirical

55 Vayanos, D., 1998, Transactions Costs and Asset Prices: A Dynamic Equilibrium Model, Journal of Financial Economics, v11, 1-58. 56 Jarrow, R. and A. Subramanian, 2001, The Liquidity Discount, Mathematical Finance, v11, 447-474. 57 Lo, A.W., H. Mamaysky and J. Wang, 2001, Asset Prices and Trading Volume under Fixed Transactions Costs, Working Paper, Yale International Center of Finance.

52

discussion in this paper supports the view that illiquidity is a problem even for publicly

traded stock, and is more of a problem for some stocks than for others.

If we accept the proposition that the value of a publicly traded stock has to be

adjusted for illiquidity, we are then faced with a secondary question. How can we

estimate the illiquidity discount? We can adopt the private appraiser practice of

discounting the estimated value of more illiquid stocks, using the studies of restricted

stock and IPOs to back up the estimated discounts. However, there is a better way. A

publicly traded stock has a bid-ask spread that provides a direct measure of illiquidity in

that stock, and that spread can be employed to estimate the appropriate discount to

estimated value. In fact, adapting the Amihud-Mendelson construct from the last section,

the illiquidity discount can be written as follows:

Illiquidity Discount = !"#  !"#$%!!"#  !"#$%(!"#  !"#$%!!"#  !"#$%)  

!!"#$%&$'  !!"#$%&  !"#$%&  !"  !"#$%!"#$  !"  !"#$%&

Intuitively, we are estimating the annualized cost of trading over the time horizon of the

investment in the numerator and then computing the present value of this cost in

perpetuity. Thus, the illiquidity discount for a stock with a cost of equity of 10%, a bid

price of $ 1.80, an ask price of $ 2.00, to an investor with a four-year holding period will

be as follows:58

Illiquidity Discount = !.!"!!.!"(!.!"!!.!")  

!!

 .!" = .125 or 12.5%

While the approach is simple, it illustrates the factors that should cause illiquidity

discounts to vary across companies, investors and time:

• Across assets: Securities with higher bid-ask spreads, as a percent of the stock

price, should have higher illiquidity discounts than stocks that have lower bid-ask

spreads. Thus, all of the factors that determine the spread indirectly determine the

liquidity discount; thus, lightly traded stocks, low priced stocks and small market

cap companies should have larger illiquidity discounts.

• Across investors: Note that the illiquidity discount will vary across potential

buyers, depending upon their liquidity preference (captured in the holding period).

It is likely that those buyers who have deep pockets, longer time horizons and see 58 The spread between the bid and the ask price is the cost of a total round trip transaction. Thus, it captures the cost of buying and later selling the same security.

53

little or no need to cash out their equity positions will attach much lower

illiquidity discounts to value, for similar firms, than buyers that do not possess

these characteristics.

• Across time: The illiquidity discount is also likely to vary across time, as the

market-wide desire for liquidity ebbs and flows and bid-ask spreads shift. In other

words, the illiquidity discount attached to the same business will change over time

even for the same buyer.

Table 2 estimates the illiquidity discount as a function of the bid-ask spread (as a percent

of the stock price) and the time horizon of the investor, assuming a cost of equity of 10%:

Table 2: Illiquidity Discount to Value: Capitalized Bid-ask spreads

Spread  as  %  of  price  

Time  Horizon  of  investor  1  year   2  years   5  years   10  years  

1%   5.00%   2.50%   1.00%   0.50%  2%   10.00%   5.00%   2.00%   1.00%  3%   15.00%   7.50%   3.00%   1.50%  4%   20.00%   10.00%   4.00%   2.00%  5%   25.00%   12.50%   5.00%   2.50%  

This approach does yield very high discounts for short-term investors in securities with

high bid-ask spreads.

An alternative: Adjust the discount rate

If illiquidity is a risk associated with an investment, it seems logical that we

should be using higher discount rates for cash flows on an illiquid investment than for

cash flows on a liquid investment. The question then becomes one of measuring

illiquidity and translating that measure into a discount rate effect.

The Theory

In conventional asset pricing models, the required rate of return for an asset is a

function of its exposure to market risk. Thus, in the CAPM, the cost of equity is a

function of the beta of an asset, whereas in the APM or multi-factor model, the cost of

equity is determined by the asset’s exposure to multiple sources of market risk. There is

little in these models that allow for illiquidity. Consequently, the required rate of return

will be the same for liquid and illiquid assets with similar market risk exposure. In recent

years, there have been attempts to expand these models to allow for illiquidity risk in one

54

of two ways. The first are theoretical models that build in a market premium for

illiquidity that affects all assets and measures of illiquidity for individual assets.

Differences in the latter will cause required rates of return to vary across companies with

different degrees of liquidity. The second are purely empirical multi-factor models that

attempt to explain differences in returns across stocks over long time periods, with a

measure of illiquidity such as trading volume or the bid-ask spread considered one of the

factors.

The earliest theoretical discussions of how best to incorporate illiquidity into asset

pricing models occurred in the 1970s. Mayers (1972, 1973, 1976) extended the capital

asset pricing model to consider non-traded assets as well as human capital.59 The

resulting models did not make explicit adjustments for illiquidity, though. In a more

recent attempt to incorporate illiquidity into expected return models, Acharya and

Pedersen (2005) examine how assets are priced with liquidity risk and make a critical

point.60 It is not just how illiquid an asset is, but also when it is illiquid. In particular, an

asset that is illiquid when the market itself is illiquid (which usually coincides with down

markets and economic recessions) should be viewed much more negatively (with a

resulting higher expected return) than an asset that is illiquid when the market is liquid.

Thus the liquidity beta of an asset will reflect the covariance of the asset’s liquidity with

market liquidity.

The empirical models take a simpler route to adjusting discount rates. Rather than

compute liquidity betas, they draw on the studies that we quoted in an earlier section,

relating expected returns on stocks to measures of liquidity (bid-ask spreads, turnover

ratios, trading volume). They incorporate one of these measures into their expected return

models as a proxy for liquidity and compute the expected return. Thus, the CAPM can be

modified:

59 Mayers, D., 1972, Nonmarketable assets and capital market equilibrium under uncertainty, in M.C. Jensen, Studies in the Theory of Capital Markets (Praeger, New York, NY); Mayers, D., 1973, Nonmarketable assets and the determination of capital asset prices in the absence of a riskless asset, Journal of Business, v46, 258-267; Mayers, D., 1976, Nonmarketable assets, market segmentation and the level of asset prices, Journal of Financial and Quantitative Analysis, v11, 1-12. 60 Acharya, V. and L.H. Pedersen, 2005, Asset Pricing with Liquidity Risk, Journal of Financial Economics, v77, 375-410.

55

Expected Return = Riskfree Rate + Beta * Equity Risk Premium + Liquidity Proxy *

Premium per liquidity unit

In summary, both the theoretical models and the empirical results suggest that we

should adjust discount rates for illiquidity, with the former focusing on systematic

liquidity as the key factor and the latter using proxies such as bid-ask spreads and

turnover ratios to measure liquidity. Both approaches also seem to indicate that the

adjustment will vary across time and will be dependent upon a market wide demand for

liquidity. Thus, for any given level of illiquidity, the expected premium added on to

discount rates will be much greater in periods when the market values liquidity more and

smaller in periods when it values it less.

In practice

To adjust the discount rate used in discounted cashflow valuation for illiquidity,

you have to add an illiquidity premium to the discount rate and derive a lower value for

the same set of expected cashflows. The asset pricing models that attempt to incorporate

illiquidity risk are not specific about how we should go about estimating the additional

premium (other than saying that it should be larger for investments which are illiquid

when the market is illiquid). There are two practical solutions to the estimation problem:

1. Add a constant illiquidity premium to the discount rate for all illlquid assets to reflect

the higher returns earned historically by less liquid (but still traded) investments, relative

to the rest of the market. This is akin to another very common adjustment made to

discount rates in practice, which is the small stock premium. The costs of equity for

smaller companies are often augmented by 3-3.5% reflecting the excess returns earned by

smaller cap companies over very long periods. The same historical data that we rely on

for the small stock premium can provide us with an estimate of an “illiquidity premium”.

• Practitioners attribute all or a significant portion of the small stock premium

reported by Ibbotson Associates to illiquidity and add it on as an illiquidity

premium.

• An alternative estimate of the premium emerges from studies that look at venture

capital returns over long period. Using data from 1984-2004, Venture Economics,

estimated that the returns to venture capital investors have been about 4% higher

56

than the returns on traded stocks.61 We could attribute this difference to illiquidity

and add it on as the “illiquidity premium” for all private companies.

If discount rates are adjusted for illiquidity, the key is to avoid double counting and not

discount the estimated value again for illiquidity.62 The peril of this approach is that it

treats illiquidity as an either/or variable rather than a continuum. In other words, an asset

is either liquid (in which case the estimated value is unchanged) or illiquid (in which case

the discount rate is adjusted upwards). As we have noted through this paper, all assets

are illiquid with the only question being one of degree.

2. Add a firm-specific illiquidity premium, reflecting the illiquidity of the asset being

valued: For liquidity premiums that vary across companies, we have to estimate a

measure of how exposed companies are to liquidity risk. Here, we have two choices:

a. Liquidity Beta approach: One alternative is to estimate liquidity betas or their

equivalent for individual companies. To get the cost of equity, we need three other

market inputs – the riskfree rate, the equity risk premium and liquidity premium for

the market and one other company specific input – the market beta for the company.

The final estimate of cost of equity is:

Cost of equity = Riskfree Rate + Beta * ERP + Liquidity Beta * Liquidity Risk Premium

The two new inputs needed to put this model to use are the liquidity beta and a liquidity

risk premium. Drawing on the work done on the liquidity based capital asset pricing

model, these liquidity betas should reflect not only the magnitude of trading volume on

an investment, but how that trading volume varies with the market trading volume over

time. In practice, you would run a regression akin to the market regression used to

estimate conventional betas, but using changes in the stock’s trading volume (rather than

price) as your dependent variable and changes in the market’s trading volume (rather than

index levels) as your independent variable. To illustrate, the volume regressions were run

for two companies: Disney, a widely held and traded stocks in the market, and Playboy 61 The sample of several hundred venture capital funds earned an annual average return of 15.7% over the period whereas the annual average return was 11.7% on the S&P 500 over the same period. They did not adjust for risk. Broken down into classes, venture capital investments in early stage companies earned 19.9% whereas investments in late stage ventures earned only 13.7%. 62 This is a common occurrence in private company valuations. Appraisers often use the build-up approach to estimate discount rates, adding small cap and other premiums to arrive at high rates. They discount cash flows at these rates to arrive at an estimated value, which they then reduce again with 20-25% illiquidity discounts.

57

Enterprises, a smaller market cap stock, with less liquidity, using monthly trading volume

from 2004-2010 (see figure 10):

Figure 10: Trading Volume Scatter Plots – January 2004 to November 2010

Disney vs S&P 500 Playboy vs S&P 500

VolumeDisney = 0.03 + 0.71 VolumeSPX VolumePlayboy = 0.50 + 1.40 VolumeSPX

Note that the illiquidity beta for Disney is 0.71, whereas it is 1.40 for Playboy

Enterprises. If these estimates are correct (and there is significant standard error in each),

Playboy is twice as exposed to liquidity variations in the market than Disney.

The liquidity risk premium is a trickier number to estimate. One solution is to use

the historical small cap or venture capital premium that we noted in the last section as the

liquidity risk premium. That would give use values of about 3-4% for the liquidity

premiu, based upon US data from 1928-2010. The second is to estimate an implied equity

risk premium for an index of all stocks and compare that premium to the implied equity

risk premium for the most liquid stocks in the market. The advantage of this approach is

that it is forward looking and dynamic; it will rise during crises to reflect changes in

illiquidity and investor concerns about it. At the start of December 2010, for instance, the

implied equity risk premium for the Wilshire 5000, a broad measure of all US stocks, was

6.28% whereas the implied equity risk premium for the Dow 30 was 4.55%. We assume,

for convenience, that 4.55% is the equity risk premium for completely liquid stocks

(liquidity beta of zero) and that the difference of 1.73% (6.28% - 4.55%) is the illiquidity

risk premium.63

63 The inconsistency, though, is that Disney is one of the Dow 30 stocks and its liquidity beta is not zero, according to the calculations. One solution would be to crea

-­‐0.5  

0  

0.5  

1  

1.5  

-­‐0.5   0   0.5  

Disney:  %

 

SPX:  %  -­‐0.5  

0  

0.5  

1  

1.5  

-­‐0.5   0   0.5  

PlayboyL:  %  

SPX:  %  

58

Bringing together these estimates, with conventional market betas that we

estimates for Disney and Playboy yields liquidity-adjusted costs of equity for these firms

in table 3:

Table 3: Cost of equity – Disney and Playboy

Company Riskfree Rate

Market Beta

Liquidity Beta

Equity Risk Premium for liquid equities

Illiquidity Premium

Cost of equity

Disney 3.32% 1.01 0.71 4.55% 1.73% 9.14% Playboy 3.32% 1.20 1.40 4.55% 1.73% 11.20%

There are two limitations with this approach. The first is that the liquidity betas are

estimated with large standard errors; changing the parameters of the regression for

Disney caused its liquidity beta to vary from 0.30 to 0.85, whereas the range for

Playboy’s beta is even wider (0.45-1.70). The second is that that there is no input for

investor characteristics. Thus, the same illiquidity-adjusted discount rate is used both by a

short-term investor who values liquidity greatly and a long-term investor, less concerned

about cashing out on his investment.

b. Liquidity Proxy approach: In the last section, we referenced several studies that tried

to quantify the impact of illiquidity on returns, by relating variation in returns to

variations in liquidity measures. In one of the referenced studies, for instance,

Amihud and Mendelson find that every 1% increase in the bid-ask spread (as a

percent of the stock price) increases the annualized return by 0.25%. Applying this

approach to estimate the cost of equity for Disney and Playboy would yield the results

in table 4:

Table 4: Liquidity Proxies: Costs of Equity

Riskfree rate Beta

Equity risk premium

Bid-ask spread as % of price

Cost of equity

Disney 3.32% 1.01 5.08% 0.20% 8.45% Playboy 3.32% 1.2 5.08% 2.00% 9.42%

Note that we have reverted back to using a composite equity risk premium of 5.08% (the

implied premium on the S&P 500) for US equities, and estimated an added premium,

based on the bid-ask spread.

59

Portfolio Management

For the last few decades, portfolio theory has pushed investors to diversify their

wealth across asset classes and to hold multiple assets within each asset class. While

illiquidity does not change this overall recommendation, it can significantly alter the

mechanics of portfolio management as well as the composition of portfolios.

Asset Allocation

In the mean variance framework, an investment is measured on two dimensions,

its expected return (which is the good dimension) and its standard deviation (the bad

one). If we follow the framework to its logical conclusion, the optimal asset allocation

mix for an investor is the one that maximizes expected return for a given level of standard

deviation. It is this rationale that led to portfolio managers to invest in real estate in the

1980s and in private equity and hedge funds in the last decade.

But what if there are significant differences in liquidity across asset classes? If

real estate and private equity are less liquid than publicly traded equities and bonds,

should that affect the asset allocation mix? The answer is clearly yes, but the extent to

which the mix will change will depend upon the liquidity needs of the investor. At one

extreme, consider an investor with significant cash needs in the near term and an

uncertain or short time horizon. Investing in illiquid asset classes, even if they offer a

good risk/return trade off, will expose the investor to significant losses, if investments

have to be liquidated to meet cash needs. At the other extreme, an investor, with no cash

needs for the short term and a long time horizon, will not be as concerned about liquidity.

In fact, this investor may overweight his or her portfolio with illiquid assets during

periods of crisis, because the risk/return trade off on these assets will be attractive (as

illiquidity drives down the prices at which these assets sell).

In effect, asset classes will have to be evaluated on three dimensions: the expected

return, the standard deviation and the illiquidity of the asset class. The optimal asset mix

for an investor will the one that maximizes expected return, subject to two constraints:

that the risk of the portfolio be less than a specified level (which will be a function of the

risk aversion of the investor) and that the liquidity of the portfolio exceed a minimal

requirement (which will be determined by an investor’s liquidity needs). Cutting through

60

the details, here is the bottom line: the optimal mix of asset classes for an investor will

reflect that investor’s liquidity preferences. Investors who value liquidity more (either

because they are short term investors or because they need the cash) will tilt away from a

liquidity-neutral mix (based upon market values) towards more liquid asset classes.

Investors who value liquidity less, both because they are long term investors and need

cash less, will tilt away from the liquidity neutral mix towards less liquid asset classes,

because they will deliver much higher returns, given their risk. The tilt towards liquid

asset classes on the part of investors who need and value liquidity and towards illiquid

asset classes on the part of investors who value liquidity less should be accentuated

during periods when market illiquidity is higher.

To the extent that market liquidity itself varies over time, there is another

dimension on which fund managers can differentiate themselves. Fund managers who can

time changes in market liquidity will generate higher returns than those that do not, by

adjusting their portfolios to hold more (less) liquid assets when markets are illiquid

(liquid). Cao, Chen, Liang and Lo (2009) examine hedge fund performance from 1994 to

2008 and find evidence that hedge fund managers have liquidity timing abilities, in the

aggregate. They decrease market exposure when market liquidity is low though they

don’t increase it when market liquidity is high. There are also wide variations across

managers in liquidity timing, and it is a key determinant of success or failure in hedge

funds that specialize in event driven, emerging market and convertible arbitrage

strategies, where liquidity plays a much larger role in determining returns. Hedge funds

that can time liquidity well generate 5-6% as excess returns on a risk adjusted basis.64

Security Selection

Since liquidity and transactions costs vary across individual assets (stocks,

bonds), there are three ways in which the differences can be incorporated into the asset

selection process. The first is to compute expected returns, net of transactions costs; this

will require that you estimate transactions costs realistically (including price impact and

the bid ask spread) and that you consider your time horizon when investing. Note that the

same stock can have different expected returns then to a short term investor than to a long 64 Cao, C., Y. Chen, B. Liang and A. Lo, 2010, Can hedge funds time market liquidity?, Working Paper, SSRN # 1537925.

61

term investor; the former has to spread the transactions costs over a much shorter holding

period and thus faces a much bigger drop in expected returns. If security choices are

made based upon these expected returns adjusted for transactions costs, investors who

value liquidity more will invest less in illiquid companies (small cap stocks and low

priced stocks) and more in liquid companies, when investing in equities, and less in low-

rated corporate bonds and more in higher-rated corporate bonds and treasury bonds.

The second and less involved way of bringing in liquidity into the security

selection process is to use liquidity screens, in conjunction with traditional screens for

price and fundamentals, to find investments. Thus, in addition to screening for stocks

with low PE ratios (pricing screen) and high growth rates (fundamental screen), you

would also look for high turnover ratios or trading volume as a liquidity screen. The

tightness of the liquidity screen will vary across investors, depending upon their need for

cash in the near term and preferences for liquidity.

The third approach extends the standard portfolio optimization process to

incorporate liquidity into your choices. Thus, rather than pick a portfolio that delivers the

highest expected returns subject to a desired level of risk, you would explicitly list a

liquidity constraint (stated in terms of transactions costs) that you want the portfolio to

meet. Lo, Petrov and Wiersbicki (2003) provide an explicit description of how this

process would work, using 50 stocks picked randomly across different market

capitalization classes. They compare the standard optimal portfolio (computed based

upon expected return and standard deviation) to a liquidity constrained optimal portfolio,

using different measures for liquidity.65 Not surprisingly, they conclude that

incorporating illiquidity costs into the decision process will increase the weights attached

to more liquid assets and decrease those associated with less liquid assets.

Note though, that, just as in the asset allocation process, variations in the demand

for liquidity across investors implies that investors who value liquidity less than the rest

of the market may be able to exploit that difference to buy illiquid investments at a

discount.

65 Lo, A.W., C. Petrov and M. Wierzbicki. 2003, It’s 11 pm – Do you know where your liquidity is? The Mean-Variance-Liquidity Frontier, Journal of Investment Management, v1, 55-93.

62

Market Efficiency

While we debate what constitutes trading costs and how to measure them, there is

a fairly simple way in which we can estimate, at the minimum, how much trading costs

affect the returns of the average portfolio manager. Active money managers trade

because they believe that there is profit in trading, and the return to any active money

manager has three ingredients to it:

Return on active money manager = Expected ReturnRisk + Return from active

trading - Trading costs

Looking across all active money managers, we can reasonably assume that the average

expected return has to be equal to the return on the market index. Thus, subtracting the

average return made by active money managers from the return on the index should give

us a measure of the payoff to active money management:

Average ReturnActive Money Managers - Return on Index = Return from Active Trading -

Trading Costs

Using this measure, the evidence is revealing. The average active money manager has

underperformed the index in the last decade by about 1%. If we take the view that active

trading adds no excess return, on average, the trading costs, at the minimum, should be

1% of the portfolio on an annual basis. If we take the view that active trading does add to

the returns, the trading costs will be greater than 1% of the portfolio on an annual basis.

There are also fairly specific examples of real portfolios that have been

constructed to replicate hypothetical portfolios, where the magnitude of the trading costs

are illustrated starkly. For decades, Value Line has offered advice to individual investors

on what stocks to buy and which ones to avoid, and ranked stocks from 1 to 5 based upon

their desirability as investments. Studies by academics and practitioners found that Value

Line rankings seemed to correlate with actual returns. In 1979, Value Line decided to

create a mutual fund that would invest in the stocks that it was recommending to its

readers. In figure 11, we consider the difference in returns between 1979 and 1991

between the fund that Value Line ran and the paper portfolio that Value Line has used to

compute the returns that its stock picks would have had.

63

The paper portfolio had an annual return of 26.2%, whereas the Value Line fund had a

return of 16.1%. While part of the difference can be attributed to Value Line waiting until

its subscribers had a chance to trade, a significant portion of the difference can be

explained by the costs of trading.

Looking at the evidence, there are three conclusions that we would draw. The first

is that money managers either underestimate trading costs, over estimate the returns to

active trading or both. The second is that trading costs are a critical ingredient to any

investment strategy, and can make the difference between a successful strategy and an

unsuccessful one. The third is that most market inefficiencies exist only on paper and in

hypothetical studies and that incorporating the transactions and trading costs that

investors face eliminates the paper profits.

Corporate Finance

How does introducing illiquidity into the discussion change corporate financial

theory and policy? In our view, it will change how firms pick projects, how much debt

they use to fund them and how much they pay out in dividends.

64

Investment Policy

The objective in investment analysis is to make resource allocation decisions that

maximize the value of the business. That objective does not change in an illiquid market

but putting it into practice becomes more difficult to do. In this section, we will begin by

looking at how the investment analysis process may have to be altered to account for

differences in liquidity across investments and then consider how to incorporate

illiquidity into costs of equity and capital.

Investment Decision Rules

The superiority of the net present value rule in investment analysis stems from the

assumption that companies can access capital markets at no cost to raise new funding for

any positive net present value rule. If we deviate from this assumption and introduce

illiquidity into the process, the choice of decision rules becomes murkier. A value-

maximizing firm that faces liquidity constraints may not be maximizing its value by

taking the highest positive net present value projects. In fact, the restrictions on raising

new capital will require these firms to maximize the percentage returns they generate on

limited capital. In fact, this is perhaps why the internal rate of return rule persists as a

widely used investment decision rule.

For those who are troubled by the potential for multiple internal rates of return

and the faulty reinvestment rate assumption that underlies the IRR rule, there is an

alternative. Continue to use the net present value rule as your primary decision rule but

introduce liquidity constraints. For instance, the payback on a project measures the

number of periods it will take for the cumulative cash flows to cover the initial

investment. The investment decision rule can then modified thus: accept projects with a

positive net present value, subject to the payback on the project not exceeding a specified

limit. There are more sophisticated liquidity measures that can also be brought into the

process, ranging from the computing and capping the duration on the project (where

duration is defined as the weighted average maturity of the cash flows) and building in

liquidity restrictions over multiple periods.

Surveys of companies back up the linkage between liquidity and the choice of

investment decision rules. Campbell and Harvey (2002) surveyed CFOs of US companies

65

and reported that while both techniques were widely used in capital budgeting, the usage

of NPV was more common at large market cap companies, which are presumably more

liquid. They also note that the second most commonly used capital budgeting technique is

payback, with almost 57% of companies adopting it at least as a secondary decision

rule.66

Cash flows (on liquid versus illiquid assets)

In an earlier section, we listed many reasons why the computed cash flow on a

project may not match up to the liquid cash flow. Cash flow computations can be adapted

to meet concerns about liquidity.

a. If the concern is that the firm may have to set aside cash flows to meet regulatory

requirements, you could estimate cash flows after the set aside, thus assuming that

the regulatory capital in untouchable as a cash flow, as long as the firm remains a

going concern.

b. If there are state restrictions or lender covenants on how much a firm can return to

investors, the cash flow can be capped to reflect the restrictions and the residual

amount can be carried forward until the constraint eases. This time delay may

reduce the present value of the cash flows, especially if the carried forward cash

has to be invested at below-market rates.

c. If there are sovereign remittance restrictions on cash flows, and the value of a

foreign project is being computed to domestic investors, the cash flow that is

discounted will reflect only that portion of the cash flows that can be remitted.

The unremitted balance will be held, earning the appropriate returns or interest,

until remittance is feasible (perhaps after a specified period or when the project

winds up). Here again, the net effect will be the potential loss in value that occurs

in that period.

d. If the cash flows are in a currency that is not liquid, there is the risk that

conversion rate may be very different from the current exchange rate. To the

extent that you can enter into privately negotiated forward contracts to protect

these cash flows from exchange rate effects, the expected cash flows on the 66 Graham, John R., and Campbell Harvey, 2002, How Do CFOs Make Capital Budgeting and Capital Structure Decisions?, Journal of Applied Corporate Finance 15, 8-23.

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project can be reduced by the costs of buying this insurance (which can be

substantial).

In summary, as cash flows on a project become less liquid, the value of the project will

decrease.

The fact that all cash flows are not equally liquid can have implications for

investment analysis. Firms that face stricter liquidity constraints are also less likely to

invest in longer term projects and especially so if those projects have cash outflows in the

earlier years and inflows in the future (such as infrastructure investments in capital

intensive businesses). Holding all else constant, you would also expect firms to invest

less in countries with significant remittance restrictions or illiquid currencies.

Cost of equity and capital

As we noted earlier, the costs of equity and capital in conventional corporate

finance are computed on the implicit assumption that equity and debt markets and

completely liquid and accessible. However, we also looked at evidence that not only are

there differences in liquidity across companies but that market illiquidity itself can vary

over time.

Incorporating illiquidity in the costs of financing will push the costs up, but how

exactly can we incorporate liquidity into costs? We have two choices:

a. Gross up for transactions costs: A simple way of incorporating transactions cost is to

gross up the cost of financing for the upfront transaction costs borne in raising the

financing. Assume that a firm is planning to raise $ 100 million in new equity capital

and that the conventional measure of cost of equity, based on the market beta or

betas, is 9%/. Assume also that the issuance cost from investment banking fees is

10%. The grossed up cost of equity for this firm can be computed as follows:

Gross Cost of equity = Conventional Cost of Equity(1! Issuance Cost as a % of proceeds)

=9%

(1!.10)=10%

While this approach is simple, it has two problems. It works best when illiquidity is

an upfront cost that can be quantified but not as well when illiquidity is a continuing

problem that creates costs over time. The second is that it creates a two tier cost for

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equity, where internal equity (retained earnings) as a lower cost than external equity

(new stock issues).

b. Adjust for liquidity risk explicitly: In the valuation section, we developed an

alternative way of adjusting the cost of equity for illiquidity explicitly, by estimating

an illiquidity beta (βjl) for a company (that captures how illiquidity in the company

covaries with market illiquidity) and an illiquidity risk premium (LRP):

Cost of equity = Rf + ! jm ERP( )+! jl (LRP)

where βjm is the conventional market beta measure and ERP is the equity risk

premium. The adjustment for illiquidity in the cost of debt should be simpler, since

lenders will charge higher interest rates during periods of illiquidity and default

spreads will reflect their preferences.

The net effect of using either approach is a higher cost of capital for illiquid companies

than for otherwise similar liquid companies and an increase in the cost of capital during

periods of market illiquidity.

What are the implications? Since liquid companies will have lower costs of

capital than their less liquid competitors, it can operate as a competitive advantage in

sectors where there are wide variations in access to capital, and can be a potential source

of synergy in acquisitions of illiquid, smaller companies by their more liquid, larger

counterparts. This may also explain why some larger market-cap emerging market

companies choose to get listed on developed markets; many Latin American and Asian

firms have depository receipts (ADRs) listed on the New York Stock Exchange. Listing

on a more liquid market can lower your cost of capital and increase firm value. Chan,

Hong and Subrahmanyam (2007) examine the pricing of ADRs on 401 companies and

attribute the differences in premiums (over the local market listing price) to differences in

liquidity.67

Capital Structure

In a liquid market, firms should choose the mix of debt and equity that minimizes

their cost of financing and/or maximized value, and match debt up to these assets. As

67 Chan, J. S. P., Hong, D., and Subrahmanyam, M. G., 2007. A tale of two prices: Liquidity and asset prices in multiple markets, Journal of Banking & Finance 32, 947-960.

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illiquidity costs rise, the trade off on using debt as opposed to equity also will change and

alter both the optimal mix for the firm and the right type of debt to use.

How much debt to use…

The items in the debt trade off are unchanged in a world with illiquidity: tax

benefits as a plus and expected bankruptcy costs and agency costs (between debt and

equity investors as a minus). What illiquidity does change is the magnitude of these items

and through them the optimal mix.

We can examine the effect of illiquidity using either of the two approaches that

we described in the earlier section. In the cost of capital approach, there are two ways in

which illiquidity plays out in the optimal debt ratio. First, the illiquidity of financial

markets affect both the cost of equity and debt. To the extent that illiquidity is more of a

problem in one market than in another, the optimal mix will be different. Thus, if equity

markets are very illiquid but bank funding is more accessible, as is the case in many

smaller emerging markets, the cost of equity will rise far more than the cost of debt, when

illiquidity is incorporated, leading to higher optimal debt ratios. Thus, the effect of

financial market illiquidity on optimal debt ratios in the cost of capital approach is

ambiguous and depends in large part on the relative illiquidity of the two markets.

Second, the illiquidity of asset markets can affect the costs of equity and debt, with the

impact being larger on the cost of debt and here is why. To the extent that lenders base

interest rates on their expectations that a firm will default and the proceeds from asset

sales, if default occurs, they will charge higher interest rates when asset markets are

illiquid than when they are liquid. Equity investors are less reliant on liquidation value

for their payoffs and thus less likely to increase their required returns to compensate for

illiquid asset markets. The net effect should be a reduction in optimal debt ratios for

firms, with the impact increasing with the illiquidity of firms. Incorporating both

financial market and asset market illiquidity into the cost of capital will generally reduce

optimal debt ratios for firms.

In the adjusted present value approach, the effect is more clear-cut. The

probability of default increases across the board as illiquidity in capital markets increase.

A firm that is unable to access capital markets, is more likely to find itself defaulting

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when debt payments come due. The cost of bankruptcy increases as illiquidity in asset

markets increases, since asset sales will deliver less in proceeds. Holding tax benefits

constant, the value added by debt will therefore decrease as illiquidity increases.

There have been studies that back up the linkage between the liquidity of

securities issued by firms and capital structure. Lipson and Mortal (2009) focus on equity

market liquidity and look at debt ratios for firms, classified based into liquidity quintiles,

and note that firms with more liquid stocks tend to have lower debt ratios than firms with

more illiquid stock; they also document that increasing leverage can increase equity

market volatility and liquidity.68 Rajan and Zingales (1995), in their comparison of

capital structure, across markets also find evidence of higher debt ratios in markets with

less liquid equity markets, though those differences can be attributed to factors other than

liquidity.69 Other studies have examined the linkage between asset market liquidity and

capital structure; if asset markets are illiquid, selling assets in the face of distress

becomes more difficult and costly, thus also increasing the cost of distress (and lowering

the net payoff to borrowing money). Alderson and Baker (1995) note that firms that face

high asset liquidation costs tend to borrow less money70 and Kim (1998) finds that firms

in the contract drilling business with more liquid assets tend to borrow more than firms

with less liquid assets.71 Benmelech, Garmaise and Moskowitz (2005) examine loans on

commercial property and find that higher asset liquidity goes with greater loan size.72

Type of Debt

Rather than match debt up to assets, which is the optimal policy when all markets

are liquid, a firm should borrow money or issue bonds in the most liquid markets and use

derivatives or forward contracts to reduce the mismatch risk. For instance, the US firm

68 Lipson, M., and S. Mortal, 2009, Liquidity and Capital Structure, Journal of Financial Markets 12, 611-644. 69 Rajan, R., and L. Zingales. “What Do We Know About Capital Structure? Some Evidence from International Data.” Journal of Finance, 50 (1995), 1421-1460. 70 Alderson, M., and B. Betker. “Liquidation Costs and Capital Structure.” Journal of Financial Economics, 39 (1995), 45-69. 71 Kim, C. “The Effects of Asset Liquidity: Evidence from the Contract Drilling Industry.” Journal of Financial Intermediation, 7 (1998), 151-176. 72 Benmelech, E.; M. Garmaise; and T. Moskowitz. “Do Liquidation Values Affect Financial Contracts? Evidence From Commercial Loan Contracts and Zoning Regulation.”, Quarterly Journal of Economics, 120 (2005), 1121-1154.

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with an Indonesian project, with rupiah cash flows, should issue US dollar bonds and

then use rupiah-dollar forward contracts or options to hedge against the exchange rate

mismatch. It is possible that some of the mismatches that emerge from this strategy

cannot be easily hedged. Thus, a firm that is forced to borrow short term to fund long

term projects, because banks will not lend long term or charge exorbitant rates to do so, is

facing additional default risk. As a consequence, it should scale down how much it

borrows to reflect this concern.

The empirical evidence on the relationship between debt type and liquidity is

limited. One study of how firms coped with the banking crisis of 2008, where both equity

and debt markets became illiquid for almost all firms, provides some insight. It notes that

firms that could access lines of credit were able to alleviate the impact of illiquidity better

than firms without that access.73 Studies that compare financing choices across countries

also find that firms in less liquid markets tend to be more dependent on short-term bank

debt than firms in developed, more liquid markets. While there are other factors that play

into these choices, having a long-term relationship with a bank can provide access to

capital during liquidity crises.

Dividend Policy

When liquidity is not a concern, companies should return excess cash to their

stockholders, the choice of dividends and stock buybacks as a cash return mechanism will

be determined by tax considerations and firms should maintain only operating cash

balances. However, all of these recommendations have to be modified when liquidity

becomes a concern.

Cash returned versus Cash held back

Consider a firm that generates $ 100 million in after-tax cash flows that are in

excess of it operating and reinvestment needs. Should this firm return the cash to

stockholders? The cash is excess cash, at least for this period, and returning it does not

adversely impact the firm at least for the near term. However, what if the firm has a cash

deficit next period of $ 100 million, either because its operating cash flows drop or

73 Campello, M., E. Giambona, J.R. Graham and C.R. Harvey, 2010, Liquidity   Management   and  Corporate  Investment  during  a  Financial  Crisis,  Working  paper,  Duke  University.  

71

because its reinvestment needs surge? In a liquid market, the firm faces no problem. It

will raise the $ 100 million, accessing either debt or equity markets, and cover its deficit.

But what if markets are either illiquid or can become illiquid? This firm may be unable to

raise $ 100 million in the next period and face all of the consequences, which can range

from the unpleasant (investment cutbacks and lower growth) to the catastrophic

(bankruptcy). It follows, therefore, that a forward-looking firm will hold back on the

excess cash of $ 100 million in the first period to cover the potential deficit in the second.

This very simplistic illustration brings home the two key changes that you would

expect in dividend policy, as you introduce either actual illiquidity or the fear of

illiquidity in the future into the discussion. The first is that we should expect less cash to

be returned to stockholders as illiquidity increases, as a percent of available cash flow,

with firms that are more exposed to illiquidity risk (smaller and riskier firms) holding

back more cash. The second is that the cash balances at firms should also increase as

illiquidity concerns rise, with the increase being proportionately greater at firms that are

more exposed to illiquidity risks.

Almeida, Campello and Weisbach (2004) use a large sample of manufacturing

firms to examine how cash holdings at firms vary as a function of the financial

constraints they face; they use multiple proxies for these constraints including payout

ratios, firm size and bond ratings.74 They conclude that firms that face more constraints in

raising capital are more likely to withhold cash and have larger cash balances. In direct

evidence of the proposition that fears of illiquidity affect cash balances at any given

company, a survey of CFOs of US companies by the Association of Finance

Professionals in 2010 found that twice as many firms increased their cash balances as

decreased them after the banking crisis in 2008.75

Dividends versus Stock buybacks

On the issue of dividends versus stock buybacks, illiquidity can play a role in the

choice. Consider a limiting example. Assume that, investors live in a world with no taxes.

To be indifferent between dividends and stock buybacks (of equal magnitude), they

74 Almeida, H., M. Campello, and M. S. Weisbach, 2004, The cash flow sensitivity of cash, Journal of Finance 59, 1777-1804. 75 2010 AFP Liquidity Survey, Association of Finance Professionals, Maryland. (www.AFPonline.org)

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should both deliver the same cash flow to investors. The cash flow from dividends arrives

directly to investors and requires no assumptions about market liquidity. To get the

equivalent cash flow from buybacks, investors who were not part of those who sold their

shares back to the company at the time of the buyback, have to be able to sell a portion of

their holdings at the higher post-buyback price to collect the cash flow. Illiquidity clearly

matters at that stage and can thus make dividends a more attractive option than buybacks

of the same dollar value. In practical terms, this would imply that stocks that pay high

dividends should be priced more highly than otherwise similar stocks that pay lower

dividends.

The argument that firms in less liquid markets should pay more dividends may

seem to contradict the conclusion in the last section, where we argued that they are likely

to hold back cash and accumulate large cash balances. Bringing in stock buybacks as an

alternative approach to returning cash to stockholders resolves the contradiction. Firms in

more liquid markets will have less incentive to accumulate cash, but they will also be

rewarded less by investors for paying dividends; they are more likely to use stock

buybacks. Firms in less liquid markets have a more difficult balancing act: they want to

accumulate larger cash balances but investors also prefer larger dividends. Not surprising,

they are less inclined to buy back stock; this may be part of the reason why buybacks are

far more common in the United States than in emerging markets. Within the same

market, we should also expect to see stock buybacks rise when markets are liquid and

decrease when concerns about market liquidity increase. That again may be part of the

reason why stock buybacks came to an almost complete standstill in the United States in

the aftermath of the banking crisis (which was also a liquidity crisis) of 2008.

The evidence backs up the proposition that liquidity and dividends are negatively

related. Banerjee, Gatchev and Spindt (2007) find evidence that less liquid firms are more

likely to initiate and increase dividends than more liquid firms and argue that declining

dividends at US firms can be attributed at least partially to increased liquidity in US

equity markets.76 Looking across countries, Griffin (2010) notes a greater propensity to

76 Banerjee, S., V. Gatchev, and P. Spindt, 2007. Stock market liquidity and firm dividend policy, Journal of Financial and Quantitative Analysis 42, 369-398.

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pay dividends in countries with less liquid stock markets.77 While there is no direct

evidence linking buybacks to liquidity, the fact that buybacks are more common in the

US than in other markets and that more liquid, large market capitalization companies are

more likely to buy back stock is consistent with the hypothesis that more liquid firms are

more likely to buy back stock.78

Conclusion Illiquidity matters. Investors are generally willing to pay higher prices for more

liquid assets than for otherwise similar illiquid assets. While this proposition is widely

accepted, there is substantial debate about how to measure illiquidity and to incorporate it

into value. In the first part of this paper, we look at how assumptions about liquidity are

critical to how we approach portfolio management and corporate finance. In the second

part, we look at the empirical evidence on how much liquidity varies across investments

and across time, and how much markets value liquidity. Considering a broad array of

investments, from government bonds to private equity, the consensus conclusion that we

draw is that illiquid investments trade at lower prices than liquid investments and

generate higher returns. The magnitude of the illiquidity discount varies across

investments, with riskier investments bearing larger illiquidity discounts, and across time,

with the discounts being greatest when the overall market itself is least liquid.

In the next part of the paper, we consider the effects of incorporating liquidity (or

its absence) into the analytical process for both investors and financial managers. For

investors, it pinpoints the importance of finding an investment strategy that matches time

horizon; less liquid investments can be a bargain to long-term investors and the capacity

to forecast shifts in market liquidity can deliver superior returns. For financial managers,

the perceived liquidity of the firm’s securities and its assets can affect investment,

financing and dividend policy. In general, firms with that face illiquid markets will invest

less in long-term projects, use debt sparingly, accumulate more cash and pay higher

dividends.

77 Griffin, C.H., 2010, Liquidity and Dividend Policy: International Evidence, International Business Research, v3, 3-9. 78 There is some evidence of a reverse causality: trading volume increases and liquidity improves after buybacks.