Market Closure and Liquidity Premia

30 Sep 15 NUS mathematicians and their coauthors find that market closure and the volatility difference across trading and nontrading periods significantly change optimal trading strategies of investors.

Prof DAI Min from the Department of Mathematics in NUS and his coauthors consider a continuous-time optimal portfolio choice problem with transaction costs. Different from the standard literature but consistent with empirical findings, they assume market closes periodically and stock return dynamics may differ across trading and nontrading periods. They find that in the absence of transaction costs, the investor almost always trades at market close and market open if Sharpe ratios vary across trading and nontrading periods, and that in the presence of even small transaction costs, however, the investor trades only infrequently.

This work also contributes to the literature on the effect of transaction costs on liquidity premia. They numerically demonstrate that if one incorporates the well-established fact that market volatility is significantly higher during trading periods, then transaction costs can have a first order effect that is comparable to empirical evidence. The main intuition for why the liquidity premium is much higher in their model is simple: The opportunity cost of not being able to rebalance costlessly to take advantage of the time-varying return dynamics is much greater when return dynamics changes significantly and frequently.

Their model suggests that conditional on the same increase in the transaction costs, stocks with greater volatility variation across trading periods and nontrading periods require higher additional liquidity premia. Indeed, their empirical analysis finds that liquidity premia are higher for stocks with greater volatility-differences across trading and nontrading periods (see Figure). For example, for a 1% increase in the bid-ask spread, stocks with high volatility-differences require 0.36% higher monthly risk adjusted excess return than those with low volatility-differences. This is the first empirical analysis indicating that volatility difference across trading and non-trading periods significantly affects liquidity premia.

This figure plots the realized returns for S&P 500 index from January 1962 to October 2008, where the red path represents the simple return from market open to market close (“daytime” return) and the blue path represents the return from market close to next market open (“overnight” return). The figure illustrates the much higher volatility during trading periods than that during nontrading periods. [Image credit: Dai Min]

Reference

M Dai, PF Li, H Liu, Y Wang. “Portfolio choice with market closure and implications for liquidity premia” Management Science, forthcoming.