Liquidity effects on momentum and reversal
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During the last decade, liquidity has been an important topic for explaining the financial market. Despite their popularity, no single measure is able to reflect the concept of liquidity as liquidity has various aspects, such as trading costs, trading quantity, trading speed, and price impact. To address this limitation used in previous studies, in my dissertation, I develop multidimensional liquidity measures and apply them to explain momentum and reversal effects—two well-known anomalies in asset pricing. In the first chapter of my dissertation, I develop multidimensional liquidity measures including price and quantity dimensions by using spread, price impact, and depth from high-frequency data. These measures are constructed using the principal component analysis and ranked liquidity method. Consistent with prior studies, both measures are good indicators that reflect economic fluctuations and overall liquidity effects (transaction costs)—namely, they decline during recessions and are sensitive to firms' sizes. As representative liquidity measures that contain multidimensional aspects, they can be easily applied to other studies in asset pricing, corporate finance or market efficiency. The second chapter of my dissertation applies my multidimensional liquidity measures to asset pricing. Specifically, this dissertation looks more closely at how liquidity has affected momentum and reversal profits from 1993 to 2010. After dividing the sample into two sub-periods, the pre-decimalization period (1993-2000) and the post-decimalization period (2001-2010), I show that momentum and reversal effects are profitable only in the pre-decimalization period. To explain these phenomena in connection with liquidity, this dissertation introduces arbitrage costs and institutional investors. First, I find that arbitrage costs deter exploiting momentum and reversal effects; transaction costs or liquidity, including multiple dimensions such as price impact, depth, and spread from the market microstructure literature, limit arbitrage for both the momentum and reversal effects while holding costs prevent only the reversal effect. Second, I show that the persistence of momentum and reversal effects is associated with activities of institutional investors, who indirectly contribute to improving liquidity. As the fraction of a company's shares that are held by institutional investors increases, the momentum effects decrease. Overall, the evidence is consistent with the conjecture that institutional investors, as arbitragers, improve the efficiency of prices through momentum trading. Finally, improvement in liquidity through the activities of institutional investors and several market reforms including the reduction to minimum tick size contributed to the disappearance of momentum and reversal effects in the later period, 2001-2010. In summary, momentum and reversal effects can be explained by liquidity that is associated with arbitrage costs and the activities of institutional investors.