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CommonalityinLiquiditybyTarunChordia,RichardRoll,andAvanidharSubrahmanyamFirstDraft,August,1998Revised,March,1999AbstractTraditionallyandunderstandably,themicroscopeofmarketmicrostructurehasfocusedonattributesofsingleassets.Littletheoreticalattentionandvirtuallynoempiricalworkhasbeendevotedtocommondeterminantsofliquiditynortotheirempiricalmanifestation,correlatedmovementsinliquidity.Butawider-anglelensexposesanimposingimageofcommonality.Quotedspreads,quoteddepth,andeffectivespreadsco-movewithmarket-andindustry-wideliquidity.Aftercontrollingforwell-knownindividualliquiditydeterminantssuchasvolatility,volume,andprice,commoninfluencesremainsignificantandmaterial.Recognizingtheexistenceofcommonalityisakeytouncoveringsomesuggestiveevidencethatinventoryrisksandasymmetricinformationbothaffectintertemporalchangesinliquidity.ContactsChordiaRollSubrahmanyamVoice:1-615-322-36441-310-825-61181-310-825-5355Fax:[phone]-5455E-mail:[e-mail]@[e-mail]:OwenSchoolofManagementVanderbiltUniversityNashville,TN37203AndersonSchoolUCLALosAngeles,CA90095-1481AndersonSchoolUCLALosAngeles,CA90095-1481AcknowledgementForconstructivecomments,suggestionsandencouragement,weareindebtedtoViralAcharya,CliffordBall,MichaelBrennan,WillGoetzmann,RogerHuang,CraigLewis,RonMasulis,GeertRouwenhorst,LakshmananShivakumar,andHansStoll,allofwhomdeclinedtoacceptanyresponsibilityfortheremainingcontents.WealsothankseminarparticipantsatArizona,Bocconi,INSEAD,Rice,andYale.ChristophSchenzlerprovidedexpertprogrammingadvice.ThefirstauthorwassupportedbytheDean’sFundforResearchandtheFinancialMarketsResearchCenteratVanderbiltUniversity.CommonalityinLiquidity,March10,19991I.MotivationI.A.TheSingle-AssetFocus.Theliteratureofmarketmicrostructurehasheretoforefocusedalmostexclusivelyonindividualsecurities.Topicssuchastransactionscostsandliquiditynaturallypertaintotherepeatedtradingofasinglehomogeneousasset.Typically,wedonotthinkoftheminamarket-widecontext,exceptperhapsasaveragesofindividualattributes.Fromtheearliestpapers(Demsetz[1968],Garman[1976]),thebid-askspreadandothermicrostructurephenomenaweremodeledwithanisolatedmarketmakerinthepivotalrole,providingimmediacyatacostdeterminedbyeitherinventoryrisks,(i.e.,alackofdiversification,(Stoll[1978a],AmihudandMendelson[1980],GrossmanandMiller[1988]),orbythespecterofasymmetricinformation(CopelandandGalai[1983],GlostenandMilgrom[1985]).Privilegedinformationconcernedanindividualstock,theinsiderservingasprototypeprivilegee(Kyle[1985],AdmatiandPfeiderer[1988]).Empiricalworkalsodealtsolelywiththetradingpatternsofindividualassets,mostoftenequitiessampledathighfrequencies,(Wood,McInish,andOrd[1985],Harris[1991]),orexaminedmicroquestionssuchasthepriceimpactoflargetrades,(KrausandStoll[1972],KeimandMadhavan[1996],ChanandLakonishok[1997]).Eventhestrandofliteratureaboutmarketdesign,(GarbadeandSilber[1979],Madhavan[1992]),examinedtheinfluenceofvarioustradingmechanismsonthecostsofindividualtransactions.Studiesofsuchtopicsasintermarketcompetitionorthecontrastbetweendealerandauctionmarketsdevolvedtopredictionsaboutindividualliquidityandtransactioncosts.Thesingle-assetfocusoftheliteratureisexemplifiedbyaprominentrecentpaper(Easley,Kiefer,andO’Hara[1997])whoseempiricalworkwasdevotedtoasinglecommonstock,AshlandOil,onthirtytradingdays.CommonalityinLiquidity,March10,19992Wedonotimplyeventheslightestcriticism.Themicrostructureliteraturehasbecomeaveryimpressivebodyofknowledge.Butweaspirebythispapertodirectsomeattentiontowardunexploredterritory,towardtheprospectthatliquidity,tradingcosts,andotherindividualmicrostructurephenomenahavecommonunderlyingdeterminants.Apriorireasoningand,asitturnsout,soundempiricalevidencesuggestthatsomeportionofindividualtransactioncostscovarythroughtime.Commonalityinliquiditycouldplayakeyroleinotherwisepuzzlingmarketepisodes.Forexample,duringthesummerof1998,creditsensitivebondsseemedtoundergoagloballiquiditycrisis.Thisprecipitatedfinancialdistressincertainhighly-leveredtradingfirmswhofoundthemselvesunabletoliquidatesomepositionstopaylenderssecuredbyother,seeminglyunrelatedpositions.1Similarly,theinternationalstockmarketcrashofOctober,1987wasassociatedwithnoidentifiablenoteworthyevent,(Roll[1988]),yetwascharacterizedbyaubiquitoustemporaryreductioninliquidity.Sincecompletingthefirstdraftofthispaper,twootherworkingpaperswithsimilarresultshaveappeared;SeeHasbrouckandSeppi[1998]andHubermanandHalka[1999].Giventhevirtualabsenceofdocumentedcommonalityintheexistingliterature,thissuddenflurryseemstoportendashiftofemphasisfromindividualassetstobroadermarketdeterminantsofliquidity.I.B.TheoreticalIntimationsofCommonalityinLiquidityTherehavebeensomesuggestivetheoreticaldevelopmentsaboutcommonliquidityinamulti-assetcontext.Forexample,Hagerty[1991]andGehrigandJackson[1998]studycompetitionamongmarketmakers,orthelackthereof,anditseffectontradingcosts.Subrahmanyam1SeetheWallStreetJournal,[1998],“Illiquiditymeansithasbecomemoredifficulttob