The Impact of Liquidity Risk: A Fresh Look*
Sebastian Stange(The Boston Consulting Group)
Christoph Kaserer(Head of the Department of Financial Management and Capital Markets, Technische Universität München)

This paper takes a fresh look at the importance of liquidity risk using a comprehensive liquidity measure, weighted spread, in a Value-at-Risk (VaR) framework. The weighted spread measure extracts liquidity costs by order size from the limit order book. Using a unique, representative data set of 160 German stocks over 5.5 years, we show that liquidity risk is an important risk component. Actually, liquidity risk is increasing the total price risk by over 25%, even at 10-day horizons and for liquid blue chip stocks and especially in larger, yet realistic order sizes beyond €1 million. When correcting for liquidity risk, it is commonly assumed that liquidity risk can be simply added to price risk. Our empirical results show that this is not correct, as the correlation between liquidity and price is non-perfect and total risk is thus overestimated.

*We would like to thank Deutsche Börse AG for providing the ‘Xetra Liquidity Measure (XLM),’ weighted spread for the major German stock indices. We are grateful to Tobias Berg, the participants of the Munich Finance Seminars and the German Finance Association Annual Meeting 2009 for helpful comments. The usual caveats apply. Comments or questions are highly welcome. An earlier version of this paper was available under the title ‘Why and How to Integrate Liquidity Risk into a VaR-Framework’ on October 30, 2008.

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Global Volatility and Forex Returns in East Asia*
Sanjay Kalra(International Monetary Fund, Washington)

During 2001-2010, increases in mature market volatility were associated with declines in forex returns for East Asian economies, consistent with an overall ‘flight to safety’ effect. Estimates from GARCH models suggest that a 10 percentage point increase in mature market equity volatility generated an exchange rate depreciation of up to 3/4 percent. This sensitivity rose during a more tranquil subsample for some countries, reflecting their greater integration with global financial markets. Long-run forex volatility increased in Asian economies after 2008, reflecting the global reach of the financial crisis in mature markets. Unconditional standard deviations estimated from these models provide operational measures of ‘long-term’ and ‘excess’ volatility in forex markets.

*I thank Nissanke Weerasinghe, Erik Leuth, and seminar participants at the Bank of Thailand for helpful comments. I am also grateful to an anonymous referee for insightful comments. All remaining errors are mine. The views expressed in this paper are mine and do not necessarily represent those of the IMF or IMF policy.

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A Dynamic Volume? Return Relation and Investors’ Positive Feedback Trading
Kotaro Miwa(Tokio Marine Asset Management)
Kazuhiro Ueda(University of Tokyo)

With individual stocks, a larger increase in trading volume indicates a stronger short-term return persistence. A reason for this short-horizon ‘volume-return relation’ is that it can signal the existence of fundamental news, which can be gradually incorporated into stock price. In this study, we present another plausible explanation by considering investors’ short-term positive feedback trading. First, through empirical analysis, we show that the volume-return relation remains strong among stocks for which there is little fundamental news. Through a model-based analysis, we demonstrate that positive feedback trading can cause this relation even when there is no news. Our findings raise the possibility that the short-horizon volume-return relation is also caused by short-term positive feedback trading.

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Low-Frequency Volatility of Yen Interest Rate Swap Market in Relation to Macroeconomic Risk*
A.S.M. Sohel Azad(Department of Accounting and Finance, Monash University/Department of Finance and Banking, University of Chittagong)
Victor Fang(Department of Accounting and Finance, Monash University)
J. Wickramanayake(Department of Accounting and Finance, Monash University)

Using ‘low-frequency’ volatility extracted from aggregate volatility shocks in interest rate swap (hereafter, IRS) market, this paper investigates whether Japanese yen IRS volatility can be explained by macroeconomic risks. The analysis suggests that this low-frequency yen IRS volatility has strong and positive association with most of the macroeconomic risk proxies (e.g., volatility of consumer price index, industrial production volatility, foreign exchange volatility, slope of the term structure and money supply) with the exception of the unemployment rate, which is negatively related to IRS volatility. This finding is fairly consistent with the argument that the greater the macroeconomic risk the greater is the use of derivative instruments to hedge or speculate. The relationship between the macroeconomic risks and IRS volatility varies slightly across the different swap maturities but is robust to alternative volatility specifications. This linkage between swap market and macroeconomy has practical implications since market makers and hedgers use the swap rate as benchmark for pricing long-term interest rates, corporate bonds and various other securities.

*We thank an anonymous referee of International Review of Finance for insightful comments and suggestions, which increased the value of this paper. A special thank to Jose Gonzalo Rangel for sharing his computer program of Spline-GARCH model. The first author is thankful to MRGS (Monash Research Graduate School, Monash University) for financial support toward his doctoral study at Monash. All remaining errors are our responsibility.

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Do Private Equity Investors Create Value for Italian Initial Public Offerings?
Antonio Meles(Business Economics Department, University Parthenope）

This study analyses the role of private equity (PE) backing in initial public offerings (IPOs) using a dataset of 227 companies that went public on the Milan Stock Exchange between January 1995 and December 2007. The evidence rejects the certification and monitoring hypotheses and provides considerable support for the market power hypothesis. In accordance with Chemmanur and Loutskina (2006), we suggest that PE investors exploit their relationships with the key IPO market players to attract attention to the IPOs of firms backed by PE, thus obtaining a higher equity valuation (both in the IPO and in the secondary market).

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